<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                   FORM 10-K

[X]   ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
      For the Fiscal Year Ending December 31, 1998

[_]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934 (No fee required)
      For the transition period from _______ to _______

                         Commission File No. 000-13059

                                 CERADYNE, INC.
                                 --------------
            (Exact name of Registrant as specified in its charter)

              Delaware                                33-0055414
    -------------------------------           ----------------------------
    (State or other jurisdiction of           (I.R.S. Employer Identifica-
     incorporation or organization)                   tion Number)

              3169 Red Hill Avenue, Costa Mesa, California  92626
             --------------------------------------------------- 
                   (Address of principal executive offices)

      Registrant's telephone number, including area code:  (714) 549-0421
                                                           --------------

       Securities registered pursuant to Section 12(b) of the Act:  None

          Securities registered pursuant to Section 12(g) of the Act:
                         Common Stock, $.01 par value
                               (Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X]   NO [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

The aggregate market value (based on the closing price at which stock was sold)
of the voting shares held by non-affiliates of the registrant as of March 3,
1999 was $19,291,216.

As of March 3, 1999, the number of shares of the registrant's Common Stock
outstanding was 8,054,838.

DOCUMENTS INCORPORATED BY REFERENCE:  None
<PAGE>
 
                                 PART I

This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934.  The Company's actual results may differ
materially from the results projected in the forward-looking statements.
Factors that might cause such a difference include, but are not limited to,
those discussed in "Item 1 - Business," including the section therein entitled
"Certain Factors that May Affect the Company's Business and Future Results," and
in "Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations."

Item 1.  Business
         --------

Introduction

Ceradyne, Inc. ("Ceradyne" or the "Company") develops, manufactures and markets
advanced technical ceramic products and components for industrial, defense,
consumer and microwave applications.  In many high performance applications,
products made of advanced technical ceramics meet specifications that similar
products made of metals or plastics cannot achieve.  Advanced technical ceramics
can withstand extremely high temperatures, combine hardness with light weight,
are highly resistant to corrosion and wear, and have excellent electrical
insulation capability and other special electronic properties.

Ceradyne's technology was originally developed primarily for defense and
aerospace applications which have historically represented a substantial portion
of its business.  However, the Company has diversified its product lines on the
development of new applications and markets, domestic and international, for its
advanced technical ceramic technology, while continuing to serve its historical
customer base which continues to account for a substantial portion of the
Company's business.

The Company continues to derive a substantial portion of its revenues from its
traditional products, such as lightweight ceramic armor for military helicopters
and microwave tube products.  However, newer products developed or being
developed by the Company for defense, industrial and consumer applications have
represented a growing share of its business.  Examples of these newer products
include (i) large corrosion resistant ceramic components sold to semiconductor
equipment manufacturers; (ii) lightweight ceramic armor vests for military
personnel; (iii) a modified translucent ceramic orthodontic bracket, which is
sold to Unitek Corporation, a subsidiary of 3M, under an exclusive marketing
agreement and marketed by Unitek under its brand name "Clarity", (iv) wear
resistant components for industrial machinery, such as paper making equipment,
made from the Company's Ceralloy(R) 147 silicon nitride advanced technical
ceramic; and (v) missile nose cones or radomes for the defense industry.

The Company has a strategic relationship with the Ford Motor Company, pursuant
to which Ford acquired a 15.0% equity interest in the Company, and transferred
ceramic-related technology to the Company with a long-term objective of
developing ceramic components for automobile engines. The Company's efforts in
automotive applications are still in the experimental stage and the Company's
ability to generate significant revenues from these applications is uncertain
and may not occur for several years, if at all.

                                       1
<PAGE>
 
Industry Background

Developments in industrial processing, military systems, microwave electronics,
consumer electronics and orthodontics have generated a demand for high
performance materials with certain properties not readily available in metals or
plastics.  In certain high performance applications, this demand has been met by
products made of advanced technical ceramics.

The following table compares certain favorable properties of selected advanced
technical ceramics commonly used by the Company with those of other selected
materials.

<TABLE>
<CAPTION>
====================================================================================================================
                               MELTING
                                POINT           HARDNESS           CHEMICAL                                 DENSITY
                              (DEGREES          (VICKERS          RESISTANCE            ELECTRICAL           (GMS
MATERIALS                    FAHRENHEIT)         SCALE)            TO ACIDS             PROPERTIES          PER CC)
--------------------------------------------------------------------------------------------------------------------
<S>                        <C>               <C>               <C>                 <C>                    <C>  
Advanced technical                                                                  From conductors to
 ceramics                  2,500 to 6,900    1,600 to 7,000        Excellent       excellent insulators   2.5 to 4.5
-------------------------------------------------------------------------------------------------------------------- 
High strength alloy
 steel                     2,500 to 2,700      250 to 900            Fair               Conductors        7.0 to 9.0
-------------------------------------------------------------------------------------------------------------------- 
High performance                                               Good to Excellent    Good to excellent
 plastics                    275 to 750          5 to 10                                insulators        1.0 to 2.0
====================================================================================================================
</TABLE>

Ceramics such as earthenware, glass, brick and tile have been made for centuries
and are still in common use today.  The inertness and lasting qualities of
ceramics are illustrated by the artifacts uncovered intact in modern times.
Almost all traditional ceramics, including those of ancient times, were based on
clay.  In recent years, significant advances have been made in ceramic
technology through the application of specialized processes to produce man-made
ceramic powders.  In the 1950's and 1960's, developments in aluminum oxide and
other oxides provided ceramics that were excellent electrical insulators and
were capable of withstanding high temperatures.  In the 1970's, these and other
developments resulted in the ability to manufacture advanced technical ceramics
with great strength at elevated temperatures and reduced brittleness,
historically a primary limitation of ceramics.  The industry that has emerged
from these advances is known as advanced technical (or structural) ceramics.

The properties of advanced technical ceramics present a compelling case for
their use in a wide array of applications.  However, manufacturing costs
associated with the production of these materials need to be reduced in order to
accelerate the use of advanced technical ceramics as a direct replacement for
metals, plastics or other ceramics.  A portion of these costs are related to the
need for diamond grinding finished components to exacting tolerances.  Industry
cost reduction efforts have included the production of blanks or feed stock to
"near net shape" configurations, thus reducing the need for final finishing.
Manufacturers are also seeking to reduce costs through the use of high volume
automated processing and finishing equipment and techniques, and to achieve
economies of scale in areas such as powder processing, blank fabrication,
firing, finishing and inspection.

The automobile industry is particularly sensitive to initial as well as life
cycle costs.  Although the current state of the art of advanced technical
ceramics suggests potential automotive acceptance, the cost factors currently
will not permit automobile related production.  The industry goal is to reduce
advanced technical ceramics costs as close as possible to the cost of equivalent
current metal parts.

                                       2
<PAGE>
 
Ceradyne Strategy

The Company's strategy is to capitalize on its existing technologies, developed
originally for defense and aerospace applications, and to broaden its product
and customer base through increased marketing efforts both domestically and
internationally.  The Company is focusing on additional customer opportunities
for existing products, and on emerging markets and products which require or can
benefit from the physical, chemical or electronic properties of advanced
technical ceramics.  To support this strategy, the Company's Advanced Ceramic
Operations in Costa Mesa, California created a new Research & Development
Department in early 1998 to focus on new materials technology.

Ceradyne seeks to increase sales of its traditional products primarily through
expanded domestic and global marketing efforts. Examples of these products and
market applications include:

     .  Lightweight ceramic armor for military applications.

     .  Industrial ceramics utilizing fused silica ceramics for the glass
        tempering and steel making markets.

     .  Microwave cathodes, microwave absorbing Ceralloy(R) ceramics and
        samarium cobalt magnets for use in microwave power tubes in
        communications, radar and electronic countermeasure applications.

In addition to the Company's strategy to leverage its existing technologies, the
Company expects much of its future growth to come from products which are
currently in early production or still in development. There can be no
assurance, however, that products still under development will be successfully
completed, or that any of these newer products, including those already in
production, will achieve wide market acceptance.  See "Certain Factors That May
Affect the Company's Business and Future Results".  The following table
illustrates these newer and planned products and the markets for which they are
intended.

                                       3
<PAGE>
 
<TABLE>
<CAPTION>
   MARKET OPPORTUNITY                      TECHNICAL DEMANDS OF MARKET                        CERADYNE'S STRATEGIC RESPONSE
----------------------------------------------------------------------------------------------------------------------------------
                                                            INDUSTRIAL
----------------------------------------------------------------------------------------------------------------------------------
<S>                              <C>                                                   <C>
Corrosion resistant non          The industry has historically  used silicon metal,    Ceradyne has created a new business unit 
oxide ceramics for use as        quartz, and aluminum oxide ceramics to fabricate      called "Semiconductor Equipment Components"
semiconductor equipment          chamber components.  Next generation equipment may    and has begun  supplying high density and
chamber components that          have operating conditions that may deteriorate        high purity nitride and carbide ceramics to
handle wafers.                   currently used materials in some sections.            several equipment suppliers.  A newly 
                                                                                       created R & D group is attempting to 
                                                                                       develop compositions tailored to each 
                                                                                       equipment manufacturer's environment. 

Wear resistant components        Failure of industrial equipment is often caused by    Ceralloy 147 Sintered Reaction Bonded Silicon
required on the rubbing or       premature wearing out of surfaces due to abrasive     Nitride (SRBSN) industrial wear parts and 
cutting surfaces of              action.  Examples include paper making where the      cutting tool inserts are designed to replace
industrial machinery, such       pulp slurry runs at 5000 feet per minute, or in       hard metal or even oxide ceramic wear 
as in paper making equipment,    metal cutting where as much as .125 inch depth of     surfaces, resulting in great productivity, 
centrifuges, and cutting tool    cut are removed in a single pass.                     quality and longer "uptime."   
inserts.                                                                             
------------------------------------------------------------------------------------------------------------------------------------

                                                              DEFENSE
------------------------------------------------------------------------------------------------------------------------------------

Lightweight armor for military   As tactical conflicts as well as terrorist and        Ceralloy 546 (boron carbide) or Ceralloy 146
and law enforcement personnel.   other activities result in the increased use of       (silicon carbide) backed with Kevlar(TM), 
                                 automatic weapons, it has become necessary to stop    Spectra(TM) or other laminates are designed 
                                 bullets as great as a .50 caliber machine gun         to provide lightweight ballistic protection 
                                 round.  However, vests or other armor must be         greater than Kevlar alone at an acceptable 
                                 light enough in weight to allow freedom of            weight. 
                                 movement without undue fatigue.
 
Missile nose cones (radomes).    Next generation tactical missiles  (Standard          The Company's advanced technical ceramic 
                                 Missile Block IV and PAC-3) will be required to       radomes are designed to address demanding 
                                 fly at extremely high velocities, tight turning       specifications of next  generation missile 
                                 radii, and severe weather conditions.  These          nose cones. 
                                 operating conditions may preclude the use of
                                 conventional polymer materials.
------------------------------------------------------------------------------------------------------------------------------------

                                                             CONSUMER
------------------------------------------------------------------------------------------------------------------------------------

Orthodontic brackets.            Traditional stainless steel orthodontic ceramic       Ceradyne's Transtar translucent orthodontic
                                 brackets are often considered unsightly.              brackets are inert, pick up the color of the
                                 Substitute clear plastic materials can be weak and    patient's teeth and allow the orthodontist to
                                 may stain.  Some orthodontic patients prefer          correct the patient's bite.  The Company and
                                 aesthetically pleasing brackets which can be          its marketing partner, 3M/Unitek, introduced
                                 affixed to each tooth to support the archwire.        an enhanced version of this ceramic bracket
                                                                                       in 1996, which is marketed by Unitek under 
                                                                                       the brand name "Clarity".
------------------------------------------------------------------------------------------------------------------------------------

                                                            AUTOMOTIVE
------------------------------------------------------------------------------------------------------------------------------------

Automobile internal combustion   In order to achieve diesel engine life of one         Ceradyne's Ceralloy 147 SRBSN is a candidate
engine and diesel engine valve   million miles and automobile engine life of over      for a variety of engine components including
train and other engine           100,000 miles without major maintenance, it may be    bucket tappet inserts, engine valves, clevis
components.                      necessary to replace metal engine components with     pins and fuel injection pump parts. The 
                                 longer lasting, lighter weight, higher temperature    Company is in prototype development of parts
                                 resistant parts at acceptable unit costs.             for Detroit Diesel Corp., Caterpillar Inc.,
                                                                                       and Ford Motor Company.  Volume production 
                                                                                       orders may not occur for several years, if 
                                                                                       at all, and will depend on significant cost
                                                                                       reduction and other factors.
------------------------------------------------------------------------------------------------------------------------------------

</TABLE>

                                       4
<PAGE>
 
As part of the Company's strategy, management intends to establish additional
sales representative and distributor relationships, particularly in
international markets.  The Company will also seek to develop strategic product
development or marketing relationships with other manufacturing companies or key
customers whose expertise, marketing or financial resources will assist the
Company in accomplishing these objectives.  See "Certain Factors That May Affect
the  Company's Business and Future Results".

Strategic Relationships

The Company has established two strategic relationships which have been, and the
Company expects will continue to be, important factors in the Company's efforts
to develop and expand its advanced technical ceramic technology into new
products and markets.  These relationships are described below.

Ford Motor Company Joint Product Development Program.  Ceradyne completed a
series of transactions with the Ford Motor Company ("Ford") in March 1986 with a
long-term objective of developing ceramic components for automobiles.  Key to
this venture was the transfer of technology developed by Ford relating to
technical ceramics, including a portfolio of United States and corresponding
foreign patents and patent applications, and the investment of $10 million in
the Company in exchange for Common Stock which eventually resulted in an
ownership interest in Ceradyne of approximately 15%.  Ford and the Company also
entered into a joint development program pursuant to which Ceradyne has been
applying its experience and expertise in technical ceramics to develop this
technology into commercial products with a view to eventually develop components
for automobile engines.  Through fiscal 1998, Ford has contributed to the
Company, on a cost sharing basis, a total of $4.5 million in cash and equipment
under this joint development program. The technology acquired from Ford and the
efforts of this joint development program have led to the development of
Ceradyne's Ceralloy(R) 147 sintered reaction bonded silicon nitride (SRBSN)
advanced technical ceramic, from which the Company now produces a line of
industrial wear components and has made prototype parts for evaluation and
testing in internal combustion and diesel engines.

3M/Unitek Orthodontic Bracket Joint Program.  In March 1986, Ceradyne entered
into a joint development and supply agreement with Unitek Corporation, a
subsidiary of Minnesota Mining and Mfg ("3M/Unitek") for the development of a
translucent ceramic bracket for orthodontic appliances commonly known as braces.
Under this agreement, 3M/Unitek, which is a major manufacturer of stainless
steel orthodontic brackets, provided Ceradyne with information regarding the
functional specifications and properties which ceramic brackets would be
required to satisfy.  Based on this information and utilizing its experience
with translucent ceramics originally produced by Ceradyne for defense electronic
countermeasure applications, Ceradyne developed, and in 1987 began
manufacturing, translucent ceramic brackets.  These brackets cosmetically blend
with the natural color of the patient's teeth while performing the structural
functions formerly performed by traditional stainless steel brackets.

Ceradyne and 3M/Unitek have obtained and jointly own two United States patents
covering the basic use of translucent ceramics for an orthodontic bracket.
3M/Unitek has an exclusive right to market brackets based on this technology
until 2007.

                                       5
<PAGE>
 
Market Applications

The Company's products can be categorized by the principal market applications
they address: (i) industrial, (ii) defense, (iii) consumer, (iv) microwave tube
products and (v) automotive.  These markets accounted for approximately 31.3%,
27.9%, 11.9%, 28.5% and .4%, respectively, of net sales for the year ended
December 31, 1996, 43.6%, 13.8%, 17.1%, 21.4%, and 4.1%, respectively, of net
sales for the year ended December 31, 1997, and 46.2%, 14.0%, 16.0%, 22.8%, and
1.0%, respectively, of net sales for the year ended December 31, 1998.

Set forth below is a description of the Company's principle products itemized by
market:

  Industrial

Industrial Wear Components. Ceradyne's industrial wear components are made
primarily of its Ceralloy(R) 147 sintered reaction bonded silicon nitride
(SRBSN).  These SRBSN ceramic components are generally incorporated in
industrial machinery where severe abrasive conditions exist which wear out vital
components.  The Ceradyne wear resistant parts are used to replace conventional
wear materials such as tungsten carbide or ceramics such as alumina or zirconia.
Often these parts are incorporated in high wear areas at the original equipment
manufacturer's plant.  Applications include metal cutting tool inserts, paper
and can making equipment, abrasive blasting nozzles as well as custom
applications.

Semiconductor Equipment Components.  This is a new market that may offer
Ceradyne growth opportunities. The equipment used to make semiconductor devices
(wafers) is extremely advanced and the newest generation has operating
environments that are harsh enough to severely limit the life of the traditional
ceramic and metal components.  Ceradyne is positioned to offer a new generation
of non oxide ceramics which have exceptional corrosion resistance.

Tempered Glass Furnace Components and Metallurgical and Industrial Tooling.
Fused silica ceramic is a ceramic which does not materially expand when heated,
nor materially contract when cooled.  Therefore, it is used to produce
industrial tooling and molds where complicated shapes and dimensions must be
maintained over a wide range of temperatures.  Such applications include the
forming and shaping of titanium metal, used in the manufacturing of aircraft.
Other applications take advantage of fused silica's excellent thermal shock
resistance and inertness when in contact with glass. These applications include
components for equipment used in the fabrication of flat plate and tempered
glass or contoured shapes such as automobile windshields.  Fused silica ceramic
shapes of up to 14 feet in length are produced in the Company's facility located
near Atlanta, Georgia.

  Defense

Lightweight Ceramic Armor.  Although armor has progressed through the centuries
from animal skin shields to metal armored suits, to Kevlar(TM) vests (for light
arms), to heavy steel plates, the requirements for light weight and maximum
projectile stopping capability vary little.  Ceradyne has developed and
currently produces lightweight ceramic armor capable of protecting against
threats as great as .50 caliber armor piercing machine gun bullets at 50% of the
equivalent steel plate weight.  Utilizing hot pressed Ceralloy(R) ceramic, the
Company's armor plates are laminated with either Kevlar(TM), Spectra(TM) or
fiberglass and formed into a wide variety of shapes, structures and components.
To date, ceramic armor manufactured by the Company has been used principally for
military helicopter crew seats and airframe panels.  The Company currently
supplies ceramic 

                                       6
<PAGE>
 
armor systems for the following helicopter programs: the Blackhawk helicopter
manufactured by Sikorsky Aircraft, the Apache helicopter manufactured by
McDonnell-Douglas Helicopters, Inc., the Cobra helicopter manufactured by the
Bell Helicopter division of Textron Inc., and the Sea King helicopter
manufactured by Westland Helicopters. The Company believes it is a leader in
producing lightweight ceramic armor for military helicopters. See "Certain
Factors That May Affect the Company's Business and Future Results".

The Company received its first production contract for ceramic armor vests for
military personnel in January 1995.  This order, from the Defense Logistics
Agency of the United States Government, was for $3.5 million in vests which the
Company shipped during 1996.

On March 2, 1998, a U.S. government agency selected Ceradyne to provide certain
ceramic armor products over a multi-year period.  Ceradyne received its first
production order under this program in October 1998 in the amount of $2.4
million.  Before this order may be shipped, the government must give final
approval to the Company's initial product samples.  Such approval is expected,
but cannot be assured.  The government has indicated that total orders over the
5-year life of this program could exceed $100 million.  However, there can be no
assurances as to the exact quantities or deliveries under this program because
the government is not required to purchase any minimum amount and all orders are
at the full discretion of the government.

Missile Nose Cones (Radomes). The Company produces conical shaped, precision
machined ceramic components, which are designed to be mounted by its customers
on the front end of tactical missiles.  These nose cones, or radomes, are
designed for applications where the velocities and operating environments are
severe enough that the thermal shock and erosion resistance, high strength and
microwave transparency properties of advanced technical ceramics are required.
Revenues from sales of radomes have not been material to date.  However, radomes
manufactured by the Company have been qualified for the Standard Missile Block
IV missile program and are currently undergoing early testing for the PAC-3
missile program.

  Consumer

Ceramic Orthodontic Brackets. In the orthodontic process of correcting a
patient's tooth alignment, typically small (about 1/4'') stainless steel
brackets are adhered to each individual tooth in order to serve as a guide to
the archwire which is the wire that sets into each bracket. The cosmetic
appearance of all this metal is often considered quite unattractive.  Ceradyne,
together with its marketing partner, 3M/Unitek, have developed and are marketing
ceramic orthodontic brackets made of Ceradyne's translucent ceramic,
Transtar(R).  The translucency of this ceramic bracket, together with the
classic ceramic properties of hardness, chemical inertness and imperviousness,
have resulted in a cosmetic substitute for traditional stainless steel brackets.
These products are generally sold as aesthetic alternatives to conventional
metal brackets and have been in production since 1987.  Ceradyne and 3M/Unitek
introduced a new enhanced ceramic bracket called "Clarity" in October of 1996.
This product has patent protection and offers new features which improve the
bracket's strength and functionality, compared to earlier designs manufactured
by the Company.  Comments from orthodontists who have purchased Clarity brackets
have been positive. The Company believes  Clarity brackets offer the
orthodontist a more robust product that will minimize treatment and chair time
while providing superior aesthetic appearance.

  Microwave Tube Products

Microwave Ceramic-Impregnated Dispenser Cathodes.  The Company manufactures
ceramic-impregnated dispenser cathodes which are used in microwave tubes for
applications in radar, satellite communications, 

                                       7
<PAGE>
 
electronic countermeasures and other uses. Dispenser cathodes, when heated,
provide the stream of electrons which are magnetically focused into an electron
beam. Microwave frequency signals which interact with this beam of electrons are
substantially increased in power. Microwave dispenser cathodes are primarily
composed of a porous tungsten matrix impregnated with ceramic oxide compounds.

Samarium Cobalt Permanent Magnets.  The Company's samarium cobalt magnets are
sold as components primarily for microwave tube applications.  Electron beams in
microwave tubes generated by the dispenser cathodes described above can be
controlled by the magnetic force provided by these powerful permanent magnets.
The magnets are generally small sub-components of microwave traveling wave
tubes.

Precision Ceramics.  Ceradyne produces a wide variety of hot pressed Ceralloy(R)
ceramic compositions, precision diamond ground to close tolerances, primarily
for microwave tube applications.  The interior cavities of microwave tubes often
require ceramic components capable of operating at elevated temperatures and in
high vacuums.

  Automotive Market

Internal Combustion and Diesel Engine Components.  The demand for higher
performance, more efficient and more durable engines for heavy duty diesel
trucks and automobiles creates additional opportunities for advanced technical
ceramics.  For instance, the Company believes that if engines could be produced
using certain advanced technical ceramic components, they could be lighter and
longer lasting than those using metal components and could operate at higher
temperatures, with reduced cooling and lubrication requirements.  As a result,
engines would use less fuel, achieve more complete combustion, thereby reducing
emissions, and be less costly to maintain.  Because of these potential benefits,
industry-wide efforts are being made to develop advanced technical ceramic
technology to replace critical steel components in diesel and automobile
engines.

Ceradyne has provided a number of prototype parts made of Ceralloy(R) 147 SRBSN
materials for evaluation and testing in internal combustion and diesel engines.
In the fourth quarter of 1998, the Company received a letter of intent for the
production of diesel engine components made from Ceradyne's Ceralloy 147-31N
sintered reaction bonded silicon nitride (SRBSN).  Production is expected to
begin in the second quarter 1999 and shipments are expected to be $1 million
during the first 12 months after shipments commence.  Contingent upon Ceradyne's
1999 performance, including meeting certain customer quality and delivery
milestones, the Company expects to receive orders for significantly higher
volumes in the future.  Also, Ceradyne is engaged in a joint development program
with Ford to develop ceramic components for automobile engines.  Ford is not
obligated to purchase any minimum quantities of components developed under this
program, and Ceradyne's efforts in this area are still in the experimental stage
with future success greatly dependent on achieving cost reductions while
maintaining high quality levels.  See "Certain Factors That May Affect the
Company's Business and Future Results".

  Other

Utilizing its advanced technical ceramics technologies and facilities, the
Company also manufactures a number of other products related to the foregoing
markets, such as dispenser cathodes for ion laser applications, samarium cobalt
permanent magnets for motors and instruments, and other precision advanced
technical ceramics.  None of these products provide a material amount of revenue
to the Company.

                                       8
<PAGE>
 
Marketing and Customers

Each of Ceradyne's three manufacturing locations maintains an autonomous sales
and marketing force promoting their individual products.  The Company has more
than 10 employees directly involved in marketing and has agreements with
manufacturers' representatives in the United States and other countries who are
compensated as a percent of sales in their territory. Ceradyne is focusing much
of its marketing effort outside the United States through direct involvement of
senior management personnel from the Company's U.S. facilities in concert with
local manufacturing representatives.  Revenues from export sales represented
approximately 20% of total net sales in 1996, 20% in 1997 and 16% in 1998.

Generally, the Company sells components to contractors or original equipment
manufacturers.  To a lesser extent, Ceradyne sells its products directly to the
end user.  The Company sells its translucent ceramic orthodontic brackets only
to 3M/Unitek pursuant to an exclusive marketing agreement with that customer.
See "Certain Factors That May Affect the Company's Business and Future Results".
For fiscal year 1996, DLA Finance Center, which purchases Ceradyne armor from
the Company, accounted for approximately 17% of net sales.  For fiscal year
1997, 3M/Unitek accounted for approximately 17% of net sales.  For fiscal year
1998, 3M/Unitek accounted for approximately 16% of net sales, and CPI, which
purchases microwave cathodes, accounted for approximately 11% of net sales.

The Company continues to explore various domestic and international marketing,
and other relationships to increase its sales and market penetration.
Furthermore, Ceradyne is attempting to create long-term relationships with its
customers to promote a smoother, more predictable flow of orders and shipments
by entering into multi-year agreements or exclusive relationships where
possible.

Manufacturing Processes

Ceradyne has a number of manufacturing processes which are dedicated to specific
products and markets.  These processes and the product applications are
described below.

Hot Pressing.  The Company's hot pressing process is generally used to fabricate
ceramic shapes for  lightweight ceramic armor and semiconductor equipment
components.  Ceradyne has developed and constructed induction heated furnaces
capable of operating at temperatures exceeding 4000F in inert atmospheres at
pressures up to 5000 lbs. per square inch.  This equipment enables Ceradyne to
fabricate parts more than 26 inches in diameter, which is considered large for
advanced technical ceramics.  Through the use of multiple cavity dies and
special tooling, the Company can produce a number of parts in one furnace during
a single heating and pressing cycle.

Ceradyne procures its raw materials (fine powders) from several outside
suppliers.  After processing by the Company, the powders are either loaded
directly into the hot pressing molds or are shaped into preforms prior to
loading into the hot pressing molds.  The powders are placed in specially
prepared graphite tooling, most of which is produced by Ceradyne.  Heat and
pressure are gradually applied to the desired level, carefully maintained and
finally reduced.  The furnace is removed from the press while cooling to permit
the press to be used with another furnace.  For most products, approximately 20
hours are required to perform this cycle.  The resultant ceramic product
generally has mechanical, chemical and electrical properties of a quality
approaching that only theoretically obtainable.  Almost all products are then
finished by diamond grinding to meet precise dimensional specifications.

                                       9
<PAGE>
 
Sintering of Fused Silica Ceramics.  Sintering of fused silica ceramics is the
process Ceradyne uses to fabricate fused silica ceramic shapes for applications
in glass tempering furnaces, metallurgical tooling and other industrial uses.
To fabricate fused silica ceramic shapes, fused silica powders are made into
unfired shapes through slip casting or other ceramic compaction processes.
These unfired "green" shapes are fired as they move through a continuously
operated 150 foot long tunnel kiln at temperatures up to 2500 degrees F. The
final shapes are often marketed in the "as fired" condition or, in some cases,
precision diamond ground to achieve specific dimensional tolerances or surface
finishes required by certain customers. See "Business, Manufacturing Processes-
Diamond Grinding".

Ceramic-Impregnated Dispenser Cathode Fabrication.  Ceramic-impregnated
dispenser cathode fabrication is used to produce cathodes for microwave power
tube applications.  To produce ceramic-impregnated dispenser cathodes, both
tungsten metal powders and ceramic powders are used.  The tungsten metal powders
are isostatically pressed in polymer tooling, removed and fired in special
atmospheres at temperatures in excess of 4000 degrees F. The tungsten billets
are machined into precision shapes with exacting tolerances. The tungsten
machined shapes are impregnated with a ceramic composite and fired at high
temperatures in special atmospheres. The ceramic impregnated components are
assembled and furnace brazed.

Final processing includes the insertion of a metal heating element within a
ceramic insulating compound and the addition of an extremely thin layer of
precious metals to the surface.  The Company's final quality inspection often
includes a test of the cathode's electron emitting capabilities at normal
operating temperatures.

Sintering and Reaction Bonding of Silicon Nitride.  The Sintering of reaction
bonding silicon nitride results in the Company's Ceralloy(R) 147 SRBSN, which is
used in industrial and automotive applications.  Ceradyne SRBSN is based on
technology acquired from Ford. See "Strategic Relationships".  This SRBSN
process begins with relatively inexpensive high purity elemental silicon (Si)
powders, which contrasts sharply with most other competitors manufacturing
techniques which start with relatively more expensive silicon nitride (Si3N4)
powders.

After additives are incorporated by milling and spray drying, the silicon
powders are formed into shapes through conventional ceramic processing such as
dry pressing.  These shapes are then fired in a nitrogen atmosphere which
converts the silicon part to a silicon nitride part.  At this step (reaction
bonding), the silicon nitride is pressure sintered in an inert atmosphere
increasing the strength of the component three fold.  As a result of SRBSN
processing, the ceramic crystals grow in an intertwining "needle-like" fashion
which the Company has named NeedleLok(TM).  Ceradyne's NeedleLok(TM) structure
results in a tough, high fracture energy part.  The process is economical due to
the low cost of the starting powders and can be used to produce extremely high
production volumes of parts due to the use of conventional pressing processes.

Fabrication of Translucent Ceramics (Transtar(R)).  Ceradyne produces
translucent aluminum oxide (Transtar(R)) components primarily for use as
orthodontic ceramic brackets.  The high purity powders are purchased from
outside vendors and processed by dedicated conventional ceramic mechanical dry
presses.  The formed blanks are then fired in a segregated furnace in a hydrogen
atmosphere at 1800 degrees C until the ceramics enter to a strong translucent
condition. These fired aesthetic appearing brackets then have certain critical
features diamond ground into them. The final step is a proprietary treatment of
the bonding side in order to permit a sound mechanical seal when bound to the
patient's teeth.

Diamond Grinding. Many of Ceradyne's advanced technical ceramic products must be
finished by diamond grinding because of their extreme hardness.  The Company's
finished components typically are machined to 

                                       10
<PAGE>
 
tolerances of +/- .001 inch and occasionally are machined to tolerances up to
+/- .0001 inch. To a limited extent, the Company also performs diamond grinding
services for customers independently of its other manufacturing processes to
specifications provided by the customer. The Company's diamond grinding
department can perform surface grinding, diameter grinding, ultrasonic diamond
grinding, diamond lapping, diamond slicing and honing. The equipment includes
manual, automatic and computer numerically controlled (CNC) grinders. The CNC
grinders have been specially adapted by the Company for precision grinding of
ceramic contours to exacting tolerances.

Fabrication of Samarium Cobalt Permanent Magnets. The fabrication of samarium
cobalt permanent magnets results in various magnet shapes which are primarily
used in microwave tube applications. The Company procures premixed samarium
cobalt powder either as SmCo5 or Sm2Co17 compositions. The powders are then
milled and formed into the final configuration by pressing in a magnetic field
using a specially designed magnet press. These "pre-fire" or "green" magnets are
then sintered at 2000 degrees F in helium or vacuum. The magnets may then be
subsequently diamond ground and characterized as to each individual magnet's
strength.

Raw Materials.  The starting raw materials for Ceradyne's manufacturing
operations are generally fine, man-made powders available from several domestic
and foreign sources. The raw materials, such as Kevlar(TM), graphite, metal
components and ceramic powders are readily available from several commercial
sources.

Quality Control.  Ceradyne products are made to a number of exacting
specifications.  In order to meet both internal quality criteria and customer
requirements, the Company has implemented a number of quality assurance and in-
process statistical process control programs.  These quality programs are
implemented separately at each of Ceradyne's three manufacturing locations.
Thermo Materials Division in Scottdale, Georgia received its ISO 9002
Certification in 1997.  Advanced Ceramic Operations in Costa Mesa, California
received its ISO 9001 Certification in 1998.

Engineering and Research

Ceradyne's engineering and research efforts consist primarily of application
engineering in response to customer requirements and to a new Research and
Development Department to focus on new materials technology.  These efforts are
directed to the creation of new products, the modification of existing products
to fit specific customer needs, or the development of enhanced ceramic process
technology.  The Company is also engaged in internally-funded research to
improve and reduce the cost of production and to develop new products.  Costs
associated with application engineering and internally-funded research are
generally expensed as incurred and are included in cost of product sales. Costs
associated with Company-funded research were approximately $400,000 in 1996,
$380,000 in 1997 and $728,000 in 1998.  The 1998 total consists of $344,000 from
the Research and Development Department, and $384,000 from the Application
Engineering Department.

Competition

Ceradyne competes on the basis of product performance, material specifications,
application engineering capabilities, customer support, reputation and price.
Competitive pressures vary in each specific product market, depending on the
product and program.  In many instances, the competitors are well-known
companies with greater financial, marketing and technical resources than
Ceradyne. Ceradyne intends to continue to focus on selected business areas in
which it can exploit its technological, manufacturing and 

                                       11
<PAGE>
 
marketing strengths. Some of Ceradyne's competitors often are divisions of
larger companies with each of Ceradyne's product lines subject to completely
different competitors. Some of the competitors of the Company include Kyocera
Corporation's Industrial Ceramics Group, Vesuvius, Mc Danel Refractories,
Cercom, Coors Ceramics Company, Spectromat, and others. In many applications the
Company also competes with manufacturers of non-ceramic materials. For future
automotive applications, there is a wide range of both current and potential
domestic and international competitors. See "Certain Factors That May Affect the
Company's Business and Future Results".

Backlog

Ceradyne records an item as backlog when it receives a contract or purchase
order indicating the number of units to be purchased, the purchase price,
specifications and other customary terms and conditions.  Ceradyne customarily
includes unexercised options as a separate item in its backlog because the
purchase orders are given on the basis of the total order, including options.
Total backlog as of December 31, 1998 was approximately $17.0 million,
consisting of $13.9 million of firm scheduled orders and $3.1 million of
unexercised options.  As of December 31, 1997 total backlog approximated $18.6
million consisting of $14.4 million of firm scheduled orders and $4.2 million of
unexercised options.  Typically, firm orders are scheduled to be shipped within
12 to 18 months from receipt of order.

Patents, Licenses and Trademarks

The Company relies primarily on trade secrecy to protect compositions and
processes that it believes are proprietary.  In certain cases, the disclosure of
information concerning such compositions or processes in issuing a patent could
be competitively disadvantageous.  However, management believes that patents are
important for technologies where trade secrecy alone is not a reliable source of
protection.  Accordingly, Ceradyne has applied for, or has been granted, several
United States patents relating to compositions, products or processes that
management believes are proprietary, including lightweight ceramic armor.

Two U.S. patents have been issued to the Company relating to translucent
ceramics for orthodontic brackets.  The earliest of these patents expires in
2007.  These patents are co-invented and co-owned by Ceradyne and 3M/Unitek.
Ceradyne and 3M/Unitek have granted licenses to eight companies whose ceramic
orthodontic brackets infringe the Ceradyne-3M/Unitek patents, wherein those
companies pay royalties to Ceradyne and 3M/Unitek based on sales of their
orthodontic ceramic brackets for the remaining life of the patents.  See
"Certain Factors That May Affect the Company's Business and Future Results", and
"Strategic Relationships".

Ceradyne has been issued two U.S. patents and has one patent pending relating to
its CRT ceramic-impregnated dispenser cathode and has applied for corresponding
foreign patents in various foreign countries.  The earliest of these patents
expires in 2006.

Through its association with Ford, Ceradyne acquired in excess of 80 U.S.
patents, of which 19 are still active, and corresponding foreign patents and
applications relating to technical ceramics for automotive technology.  The last
of these patents will expire in August 2007.  See "Strategic Relationships".

"Ceralloy(R)," the name of Ceradyne's technical ceramics, "Ceradyne(R)" and the
Ceradyne logo, comprising the stylized letters "CD(R)", are major trademarks of
the Company which have been registered in the United States and various foreign
countries.  The Company also has other trademarks, including "Transtar(R)",
"Semicon(R)", "Thermo(R)", "Isomolded(R)" and "NeedleLok(TM) ".

                                       12
<PAGE>
 
Employees

At December 31, 1998, Ceradyne employed approximately 300 persons, including 14
employees with undergraduate or graduate degrees in ceramic engineering.
Management considers its employee relations to be excellent.  The Company has
not experienced difficulty in attracting personnel.  None of the Company's
employees are represented by a labor union.

Certain Factors That May Affect the Company's Business and Future Results

This annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934.  The Company's actual results may differ
materially from the results projected in the forward-looking statements.
Factors that might cause such a difference include, but are not limited to, the
following:

We Have a History of Losses Although We Have Been Profitable Since Fiscal Year
1995

We were profitable in fiscal 1995, 1996, 1997 and 1998, after losing
approximately $21.4 million during fiscal years 1987 through 1994.  A number of
factors caused our losses.  Foremost was a decline in revenues due in part to
reduced government spending on defense-related products.  In the past, these
products represented the majority of our business.  We expect defense-related
products to represent a substantial portion of our business in the foreseeable
future.  Therefore, future declines in government defense-related expenditures
may adversely affect our future profitability.

Past losses were also caused by declines in sales of our translucent ceramic
orthodontic bracket, from peak revenues of $6.2 million in 1988 to $.4 million
in 1994.  Sales of this bracket declined in part because our exclusive bracket
distributor, Unitek Corporation, a subsidiary of Minnesota Mining & Mfg. Co.,
had accumulated excess inventory levels.  Sales also declined because technical
problems caused some orthodontists to resist using earlier versions of the
bracket.

To maintain profitability and achieve revenue growth, we must, among other
things:

     .  develop the capacity to manufacture ceramic body armor in volume and to
        address other opportunities for the use of our ceramics in armor
        applications
     .  sell significant amounts of the newest version of our translucent
        orthodontic bracket product, marketed by Unitek under the brand name
        "Clarity";
     .  develop the capacity to successfully manufacture semiconductor equipment
        components in volume and at acceptable profit margins; and
     .  continue to upgrade our technologies and commercialize products and
        services incorporating such technologies.

If we do not successfully manage the factors that led to our losses, if we fail
to develop, manufacture and market profitable, high-quality ceramic products, or
if factors beyond our control reduce sales or profitability, we may not improve,
or even sustain, our current profitability.

                                       13
<PAGE>
 
     We Must Successfully Develop and Market New Products; We have Limited
Volume Manufacturing Experience for Products Under Development

Our future prospects will depend to a large extent on the success of products
which currently provide little revenue or which remain under development. These
products include:

     .  semiconductor equipment components;
     .  lightweight ceramic armor vests for military personnel; and
     .  ceramic components for automobile and diesel engines.

We are developing ceramic automotive and diesel engine components based on our
belief that a significant market for these products will emerge.  However,
predicting future demand for such components is fraught with uncertainties.
This is a new and evolving market and advanced technical ceramics are not
currently used in any significant automotive applications.  It is possible that
such applications will never emerge.

Even if a market emerges, our efforts to produce ceramic components for
automobile and diesel engines remain in the experimental stage.  To successfully
produce these components, we must significantly lower manufacturing costs and
develop high volume manufacturing capabilities while maintaining component
quality.  If we meet our production goals, it typically takes several years to
introduce new materials and components into production automobiles.  Thus,
demand for these products and our ability to service such demand are subject to
a high degree of uncertainty.

Nevertheless, we believe that such a market will emerge eventually and that we
will be well-positioned to capitalize on it.  We have received a letter of
intent for the production of diesel engine components made from Ceradyne's
Ceralloy 147-lN sintered reaction bonded silicon nitride (SRBSN).  We expect to
begin production late in the first quarter of 1999 and to ship approximately $1
million annually starting in the second quarter of 1999.  Contingent upon our
1999 performance, including meeting certain customer quality and delivery
milestones, we anticipate significantly higher sales volumes in the year 2000
and beyond.

     Failure to Manage Our Growth Could Adversely Affect Us

Our current introduction of new products is placing, and will continue to place,
a significant strain on our resources and personnel.  To continue our growth, we
must introduce new products that apply our core advanced technical ceramic
technologies.  Managing this transition to new products will strain our
operational, financial and managerial resources into the foreseeable future.

To effectively manage growth, particularly given the increasingly international
scope of our operations, we must:

     .  add manufacturing capacity and personnel;
     .  continue to implement and improve our operational, financial and
        management information systems;
     .  develop the management skills of our managers and supervisors;
     .  add new management personnel and improve the expertise of existing
        management personnel; and
     .  train, motivate and manage our employees.

                                       14
<PAGE>
 
Any failure to effectively manage growth could have material adverse effects on
our business, operating results and financial condition.

     We Depend on Joel P. Moskowitz and Our Other Key Personnel

Our success largely depends on the continued service of our principal managers.
Many of these managers, and in particular Joel P. Moskowitz, who is Chairman,
Chief Executive Officer and President, and a principal stockholder of Ceradyne,
would be extremely difficult to replace.  We also depend on other key personnel,
and our ability to attract, motivate and retain highly qualified personnel.

Competition for skilled employees is intense and there can be no assurance that
we will be able to recruit and retain such personnel.  In addition, although Mr.
Moskowitz has an employment agreement with us that expires in July 1999, no
other employee has an agreement for a specified term of employment with
Ceradyne.  If we are unable to retain our existing managers and employees or
hire and integrate new employees, it could have material adverse effects on our
business, operating results and financial condition.

     The Advanced Technical Ceramics Markets Are Highly Competitive

The markets for applications of advanced technical ceramics are competitive.  We
believe the principal competitive factors in these matters are:

     .  product performance;
     .  material specifications;
     .  application engineering capabilities 
     .  customer support
     .  reputation; and
     .  price

At present, while we believe that we compete favorably with respect to these
factors, this may change.  If we fail to address our competitive challenges,
there could be material adverse effects on our business, financial condition and
results of operations.

Our competitors include divisions of larger companies and manufacturers of non-
ceramic materials.  Many of these competitors, both domestic and international,
have greater financial, marketing and technical resources than we do.  Our
primary competitors include Kyocera Corporation's Industrial Ceramics Group,
Vesuvius, McDanel Refractories, Cercom, Coors Ceramics Company, Spectromat, and
others.  No only do we compete with many large companies, but each of our
product lines competes with completely different companies.

We cannot guaranty that we will be able to compete successfully against our
current or future competitors or that competition will not have material adverse
effects on our business, operating results and financial condition

     We Could Be Liable for Violations of Environmental Laws and Regulations

We are subject to a variety of environmental regulations relating to the use,
storage, discharge and disposal of hazardous materials used to manufacture our
products.  Authorities could impose fines, suspend production, alter our
manufacturing processes, or stop our operations if we do not comply with these
regulations.

                                       15
<PAGE>
 
In the past, we produced certain products using beryllium oxide, which is highly
toxic in powder form.  This powder, if inhaled, can cause chronic beryllium
disease in a small percentage of the population.  In recent years, we have been
sued by former employees and a family member of a former employee alleging that
they had contracted chronic beryllium disease as a result of exposure to
beryllium oxide powders used in our products.  We settled several of these
claims without incurring material liability, but several lawsuits are still
pending.  We cannot guaranty that we will avoid future liability to persons who
allege that they contracted chronic beryllium disease as a result of exposure to
beryllium oxide utilized by Ceradyne.

While we believe we are in material compliance with all applicable environmental
statutes and regulations, any failure to comply with current or subsequently
enacted statutes and regulations could subject us to liabilities, fines or the
suspension of production.  Furthermore, claims asserted against us related to
exposure to beryllium oxide powder may not be covered by insurance.  Even if
covered, the amount of insurance may be inadequate to cover any adverse
judgment.

Fines and other punishments imposed in connection with environmental violations
and expenses related to remediation or compliance with environmental regulations
and future liability for incidences of chronic beryllium disease contracted by
employees could have material adverse effects on our business, operating results
and financial condition.

We were recently notified by the United States Environmental Protection Agency
that Ceradyne is a responsible party in the federal Superfund cleanup of the
Casmalia Disposal Site located in Santa Barbara County, California.  The
notification states that Ceradyne, along with approximately 10,000 other
companies, has been designated as a de minimus waste generator due to the
relatively small quantity of the waste disposed at the Casmalia Disposal Site.
We properly disposed of this waste material in the 1970s and 1980s.  However,
waste materials disposed at the Casmalia Disposal Site have leaked into the
water table.  Under federal law, all parties who have disposed of waste
materials at the Casmalia Site must pay their proportional share of the cost of
the cleanup effort.  In the fourth quarter of 1998, we recorded an expense in
the amount of $0.2 million as the estimated amount of our share of the cleanup
costs.  We are currently investigating whether we are entitled to reimbursement
for this cost under our insurance policies.

     We Depend Upon Sales to Agencies of the United States Government; We Face
the Risk That a Key Government Contract May be Terminated

We have a $17.0 million backlog of orders as of December 31, 1998.  Of this
amount, approximately $8.5 million, or 50%, represents orders for defense
applications.  These orders are closely tied to the level of U.S. defense
spending.  Certain contracts for helicopter armor are directly or indirectly
with agencies of the United States government.  Moreover, we anticipate that a
significant percentage of our revenues for the foreseeable future will derive
from direct or indirect sales to government agencies.

In recent years, the budgets of many government agencies have been reduced,
causing some of our customers and potential customers to re-evaluate their
needs.  However, this trend was partially arrested in the first quarter of 1998.
A U.S. government agency selected Ceradyne to provide certain ceramic armor
products over a 5-year period.  We received our first production order under
this program in October 1998 in the amount of $2.4 million.  The government has
indicated that it may order as much as $100 million or more in products from us
over the 5-year life of this program, but there is no minimum amount that the
government is required to purchase and all orders are at the full discretion of
the government.

                                       16
<PAGE>
 
Under U.S. law, defense-related contracts may be canceled by the government for
convenience at any time and without cause.  If that happens, we receive
reimbursement only for the expenses we actually incurred.  Any such
cancellations could have material adverse effects on our business, operating
results and financial condition.

     Sales of our Ceramic Orthodontic Brackets Depend on Our Exclusive Marketing
and Sales Relationship with Unitek

We developed our translucent ceramic orthodontic bracket pursuant to a joint
development agreement with Unitek.  We sell this product only to Unitek pursuant
to an exclusive marketing agreement which expires in 2007.  Consequently, our
sales of this product depend entirely on Unitek's marketing and sales efforts.

We also depend on customer and technical feedback from Unitek for the design of
improvements to the bracket.  Some orthodontists were reluctant to use early
versions of this product.  They preferred  using traditional stainless steel
brackets and were wary of certain technical problems associated with earlier
versions of our ceramic bracket.  These problems included:

     .  difficulty in removing, or debonding, the bracket from the tooth;
     .  breakage of brackets during the treatment process more often than
        experience with stainless steel brackets; and
     .  slower movement of the metal arch wire through the ceramic brackets,
        resulting in longer treatment times than with stainless steel brackets.

Designs introduced in October 1996 under the Unitek brand name "Clarity" are
intended to improve certain features of earlier versions of the bracket, but we
cannot guaranty that these new products will completely eliminate the
aforementioned problems or will receive wide market acceptance.  Furthermore, we
cannot guaranty that Unitek will devote substantial marketing efforts to sales
of our orthodontic products, or that Unitek will not reassess its commitment to
our technologies or develop its own competitive technologies.  If Unitek fails
to actively market our orthodontic brackets, or such brackets fail to  achieve
market acceptance, there may be material adverse effects on our business,
operating results and financial condition.

     We Depend on Our International Sales; We are Subject to Risks Associated
with Operating in International Markets

Shipments to customers outside of the United States accounted for approximately
20% of our sales in 1996, 20% in 1997, and 10% in 1998. We anticipate that
international shipments will account for a significant portion of our sales for
the foreseeable future.  Therefore, the following risks associated with
international business activities could have material adverse effects on our
performance:

     .  burdens of comply with multiple and potentially conflicting foreign laws
        and regulations, including export requirements, tariffs and other
        barriers, health and safety requirements, and unexpected changes in any
        of the foregoing.

     .  difficulty in obtaining export licenses from the U.S. government;
     .  differences in intellectual property protections;
     .  longer accounts receivable payment cycles;

                                       17
<PAGE>
 
     .  potentially adverse tax consequences due to overlapping or differing tax
        structures;
     .  fluctuations in currency exchange rates; and
     .  risks associated with sales to foreign government agencies similar to
        the risks associated with dealing with U.S. government agencies.

We have traditionally invoiced all of our foreign sales in U.S. dollars.
Accordingly, we do not currently engage in foreign currency hedging transactions
that could protect against the risk of currency fluctuations.  This approach
could pose risks.  If the U.S. dollar were to become more expensive relative to
the currencies of our foreign customers, the price of our products in those
countries rises and our sales into those countries, or our profitability within
those countries, may fall.

Future international activity may require that we denominate foreign sales in
the local currencies of our customers.  In that case, if the U.S. dollar were to
become more expensive relative to the currencies of our foreign customers, we
would receive fewer U.S. dollars for each unit of foreign currency that we
receive when our customers pay us. Therefore, a more expensive U.S. dollar would
cause us to incur losses upon the conversion of accounts receivable denominated
in foreign currencies.  Such losses could harm our results of operations

We cannot export some of our products to certain foreign countries without an
export license obtained from the U.S. government. We have experienced difficulty
in obtaining licenses to export our products to certain  countries.  Similar
difficulties may arise again in the future.  If any of the above risks emerge,
there may be material adverse effects on our business, operating results and
financial condition.

     We May be Adversely Affected If We Are Unable to Adequately Safeguard Our
Intellectual Property or If We Infringe on Other's Intellectual Property

We rely on a combination of patents, trade secrets, trademarks, and other
intellectual property law, nondisclosure agreements and other protective
measures to preserve our proprietary rights to our products and production
processes.  These measures afford only limited protection and may not preclude
competitors from developing products or processes similar or superior to ours.
Moreover, the laws of certain foreign countries do not protect intellectual
property rights to the same extent as the laws of the United States.

Although we implement protective measures and intend to defend our proprietary
rights, there can be no assurance that these efforts will succeed.  We may have
to litigate within the United States or abroad to enforce patents issued or
licensed to us, to protect trade secrets or know-how owned by us or to determine
the enforceability, scope and validity of our proprietary rights and the
proprietary rights of others.  Enforcing or defending our proprietary rights
could be expensive and might not bring us timely and effective relief.

Furthermore, there can be no assurance that our products or processes are not in
violation of the patent rights of third parties, or that any of our patents will
not be challenged, invalidated or circumvented.  Although there are no pending
or threatened intellectual property lawsuits against us, we may face litigation
or infringement claims in the future.  Infringement claims could result in
substantial costs and diversion of our resources even if we ultimately prevail.
A third party claiming infringement may also obtain an injunction or other
equitable relief which could effectively block the distribution or sale of
allegedly infringing products.  Although we may seek licenses from third parties
covering intellectual property that we are allegedly infringing, we cannot
guarantee that any such licenses could be obtained on acceptable terms, if at
all.

                                       18
<PAGE>
 
If we fail to adequately protect our intellectual property, or if we face claims
for infringement on the intellectual property of third parties, there may be
material adverse effects on our business, operating results, and financial
condition.

Item 2.  Properties
         ----------

The Company serves its markets from three manufacturing facilities across the
United States.  The Company's Advanced Ceramic Operations, located in Costa
Mesa, California, primarily produces armor and orthodontic products, components
for semiconductor equipment, and houses the Company's SRBSN research and
development activities.  The Company's cathode development and production are
handled through its Semicon Associates division located in Lexington, Kentucky.
Fused silica products, including missile radomes, are produced at the Company's
Thermo Materials division located in Scottdale, Georgia.  These three facilities
comprise approximately 74,000, 35,000 and 85,000 square feet, respectively.  The
Company's Costa Mesa and Scottdale facilities are held under long-term leases
which expire in October 2000 and December 2000, respectively.  The Company owns
its Lexington, Kentucky facilities.

Ceradyne's manufacturing structure is summarized in the following table:

<TABLE>
<CAPTION>

====================================================================================================================================

                FACILITY LOCATION                                                    PRODUCTS
------------------------------------------------------------------------------------------------------------------------------------

<S>                                                                  <C> 
Advanced Ceramic Operations                                          . Semiconductor Equipment Components
Costa Mesa, California                                               . Lightweight ceramic armor
   Approximately 74,000 square feet                                  . Orthodontic ceramic brackets
                                                                     . Ceralloy(R) 147 SRBSN wear parts
                                                                     . Precision ceramics
                                                                     . Ceralloy(R) 147 SRBSN diesel/automotive engine parts (R&D)
 -----------------------------------------------------------------------------------------------------------------------------------

Semicon Associates                                                   . Microwave ceramic-impregnated dispenser cathodes
Lexington, Kentucky                                                  . Ion laser ceramic-impregnated dispenser cathodes
   Approximately 35,000 square feet                                  . Samarium cobalt magnets
 
Thermo Materials                                                     . Glass tempering rolls (fused silica ceramics)
Scottdale, Georgia                                                   . Metallurgical tooling (fused silica ceramics)
   Approximately 85,000 square feet                                  . Missile radomes (fused silica ceramics)
                                                                     . Castable and other fused silica product
====================================================================================================================================

</TABLE>



Item 3.  Legal Proceedings
         -----------------
The Company is, from time to time, involved in various legal and other
proceedings that relate to the ordinary course of operating its business,
including, but not limited to, employment-related actions and workers'
compensation claims.

In October 1995 the Company was served with a complaint that was filed by four
persons and the spouses of those persons, who are/were employed by one of the
Company's customers.  The complaint, filed in the United States District Court,
Eastern District of Tennessee, alleges that the employees contracted chronic
beryllium disease as a result of their exposure, during the course of their
employment with the Company's customer, to beryllium-containing products sold by
Ceradyne.  The complaint seeks compensatory damages in the amount of $3.0
million for each of the four plaintiffs who were employed by the Company's
customer, compensatory damages of $1.0 million each for the two spouses, and
punitive damages in the amount of $5.0 million.  Based upon information
currently available, the Company believes that the plaintiffs' claims are
without merit and that the resolution of this matter will not have a material
adverse effect on the financial condition or operations of 

                                       19
<PAGE>
 
the Company. Defense of this case has been tendered to the Company's insurance
carriers, some of which are providing a defense subject to a reservation of
rights. There can be no assurance, however, that this claim or any of the claims
related to exposure to beryllium oxide will be covered by insurance, or that, if
covered, the amount of insurance will be sufficient to cover any potential
judgment.

In February 1997 the Company was served with a complaint that was filed by a
former employee of one of the Company's customers and his wife.  The complaint,
filed in the United States District Court, Eastern District of Tennessee,
alleges that the husband contracted chronic beryllium disease as a result of his
exposure to beryllium-containing products sold by Ceradyne.  The complaint seeks
compensatory damages in the amount of $5.0 million for the husband, $1.0 million
for the wife, and punitive damages in the amount of $10.0 million.  The Company
believes that the plaintiffs' claims are without merit and that the resolution
of this matter will not have a material adverse effect on the financial
condition or operations of the Company.  Defense of this case has been tendered
to the Company's insurance carriers, some of which are providing a defense
subject to a reservation of rights.  There can be no assurances, however, that
this claim will be covered by insurance, or that, if covered, the amount of
insurance will be sufficient to cover any potential judgment.

In August 1997 the Company was served with a complaint filed by a former
employee of one of the Company's customers and his wife.  The complaint, filed
in the United States District Court, Eastern District of Tennessee, alleges that
the husband contracted chronic beryllium disease as a result of his exposure to
beryllium-containing products sold by Ceradyne.  The complaint seeks
compensatory damages in the amount of $5.0 million for the husband, $1.0 million
for the wife, and punitive damages in the amount of $10.0 million.  The Company
believes that the plaintiffs' claims are without merit and that the resolution
of this matter will not have a material adverse effect on the financial
condition or operations of the Company.  Defense of this case has been tendered
to the Company's insurance carriers, some of which are providing defense and
indemnification subject to a reservation of rights. There can be no assurances,
however, that this claim will be covered by insurance, or that, if covered, the
amount of insurance will be sufficient to cover any potential judgment. 

In February 1999 the Company was served with a complaint filed by a former
employee of one of the Company's customers and his wife. The complaint, filed in
the United States District Court, Eastern District of Tennessee, alleges that
the husband contracted chronic beryllium disease as a result of his exposure to
beryllium-containing products sold by Ceradyne. The complaint seeks compensatory
damages in the amount of $5.0 million for the husband, $1.0 million for the
wife, and punitive damages in the amount of $10.0 million. The Company believes
that the plaintiffs' claims are without merit and that the resolution of this
matter will not have a material adverse effect on the financial condition or
operations of the Company. Defense of this case has been tendered to the
Company's insurance carriers. There can be no assurances, however, that this
claim will be covered by insurance, or that, if covered, the amount of insurance
will be sufficient to cover any potential judgment.


Item 4. Submission of matters to a vote of security holders
        ---------------------------------------------------

  Not applicable

                                       20
<PAGE>
 
                                   MANAGEMENT

Executive Officers of the Registrant.

     The executive officers of the Company as of March l, 1999 are as follows:

<TABLE>
<CAPTION>
         Name             Age                  Position
----------------------    ---                  --------
<S>                       <C>  <C>
Joel P. Moskowitz.....    59   Chairman of the Board, President and Chief
                               Executive Officer
Earl E. Conabee.......    61   Vice President, and Director of Marketing at
                               Thermo Materials
Garry  DeBoer.........    62   Vice President, and President of Semicon
                               Associates
Howard F. George......    54   Vice President Finance, Chief Financial
                               Officer and Secretary
Donald A. Kenagy......    57   Vice President, and President of Thermo
                               Materials
David P. Reed.........    44   Vice President, and General Manager of
                               Advanced Ceramic Operations
</TABLE>

     Joel P. Moskowitz co-founded the Company's predecessor in 1967. He served
as President of the Company from 1974 until January 1987, and from September
1987 to the present. Mr. Moskowitz currently serves as Chairman of the Board,
President and Chief Executive Officer of the Company, which positions he has
held since 1983. Mr. Moskowitz currently serves on the Board of Trustees of
Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from
Alfred University in 1961 and an M.B.A. from the University of Southern
California in 1966.

     Earl E. Conabee joined the Company in July 1985, and has served as Vice
President of the Company since June 1986.  Mr. Conabee serves as Vice President
of Marketing for the Company's Thermo Materials division, where he is
responsible for the overall marketing and sales effort for fused silica
ceramics.  Prior to joining the Company, Mr. Conabee served as General Manager
of Ceramatec, a manufacturer of technical ceramics, from 1983 to 1985, and as
Director of Refinery Operations for Englehard Minerals Corporation from 1973 to
1983.  Mr. Conabee obtained a B.S. in Ceramic Engineering from Alfred University
in 1960.

     Garry DeBoer joined the Company  as President of its Semicon Associates
Division in September 1997.  Mr. DeBoer attended Newark College of Engineering,
majoring in Metallurgy.  He has spent most of his career in the field of
microwave electronics, used primarily in military defense systems and commercial
satellite communications.  For the past twenty-five years prior to joining the
Company, Mr. DeBoer was employed by Varian Associates and Communications and
Power Industries in various Senior Technical and Management positions, and also
served as Manager of Commercial Products for CPI's Traveling Wave Tube Product
Division.

                                       21
<PAGE>
 
     Howard F. George joined the Company in December 1995 and serves in the
positions of Vice President Finance, Chief Financial Officer, and Corporate
Secretary.  Prior to joining Ceradyne, Mr. George was Chief Financial Officer of
Richmond Technology, Inc. and Chief Operating Officer of its subsidiary, Static
Control Services from 1992 to 1995.  From 1990 to 1992, Mr. George was Vice
President of Finance for Sunset Richards, a subsidiary of Hanson, PLC.  Mr.
George earned his B.A. degree in Business and Economics in 1970 at California
State University Long Beach, and an MBA from Pepperdine University, Malibu in
1980.

     Donald A. Kenagy joined the Company in December 1986 when the Company
acquired Thermo Materials, and has served as Vice President of the Company since
July 1991. Mr. Kenagy is currently President of the Company's Thermo Materials
division, and as such is responsible for the operations, finances and marketing
of Thermo Materials. Mr. Kenagy joined Thermo Materials in 1972. Mr. Kenagy
received a B.S. in Ceramic Technology from Penn State in 1963, an M.S. in
Metallurgy from the Massachusetts Institute of Technology in 1965, and a Met.
Eng. degree from MIT in 1968.

     David P. Reed joined the Company in November 1983, and has served as Vice
President since January 1988.  Mr. Reed is responsible for the operations,
finances and marketing of the Company's Costa Mesa, California operations.
Prior to joining the Company, Mr. Reed served as Manager, Process Engineering
for the Industrial Ceramic Division of Norton Co. from 1980 to 1983. Mr. Reed
obtained a B.S. in Ceramic Engineering from Alfred University in 1976 and an
M.S. in Ceramic Engineering from the University of Illinois in 1978.

Officers serve at the discretion of the Board of Directors except for Mr.
Moskowitz, who serves pursuant to a five-year employment agreement which expires
in July 1999.

                                       22
<PAGE>
 
                                    PART II

Item 5.   Market for the Registrant's Common Equity and Related Stockholder 
          -----------------------------------------------------------------
          Matters
          -------

The Company's Common Stock is traded on the Nasdaq National Market under the
symbol CRDN. The following table sets forth for the calendar quarters indicated
the high and low closing sale prices per share on the National Market as
reported by Nasdaq.  As of January 2, 1999, the Company had approximately 529
record holders of its Common Stock.

<TABLE>
<CAPTION>
                                                      High         Low
                                                    --------    ---------
<S>                                                 <C>         <C>
                                                                
Year ended December 31, 1998                                    
     First Quarter...............................    8 1/8        3 5/8
     Second Quarter..............................    7 1/2        4 1/2
     Third Quarter...............................    5 9/16       3
     Fourth Quarter..............................    5 1/8        3 1/8
                                                                
Year ended December 31, 1997                                    
     First Quarter...............................    9 1/8        5 7/8
     Second Quarter  ............................    6 3/8        4 1/4
     Third Quarter...............................    9 5/8        4 5/8
     Fourth Quarter..............................    6 31/64      3 3/4
</TABLE>

The present policy of Ceradyne is to retain earnings for the operation and
expansion of its business.  Ceradyne has never paid cash dividends, and
management does not anticipate that it will do so in the foreseeable future.

The Company did not sell any equity securities during the year ended December
31, 1998 that were not registered under the Securities Act of 1933.

                                       23
<PAGE>
 
Item 6.   Selected Financial Data
          -----------------------

Statements of Operations Data: (Amounts in thousands, except per share data)
-----------------------------                                               

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                       ------------------------------------------------
                                         1998      1997      1996      1995      1994
                                       --------  --------  --------  --------  --------
<S>                                    <C>       <C>       <C>       <C>       <C>
Net Sales                               $26,279   $28,693   $28,212   $23,404   $17,996
Cost of product sales                    21,292    23,274    21,065    16,948    15,867
                                        -------   -------   -------   -------   -------
Gross profit                              4,987     5,419     7,147     6,456     2,099
                                        -------   -------   -------   -------   -------
Operating expenses:                                                             
Selling                                   1,494     1,515     1,571     1,492     1,502
General & administrative                  3,239     3,660     3,137     2,748     2,535
Research and development                    344        --        --        --        --
                                        -------   -------   -------   -------   -------
                                          5,077     5,175     4,708     4,240     4,037
                                        -------   -------   -------   -------   -------
Income (loss) from operations               (90)      244     2,439     2,216    (1,938)
                                                                                
Other income (expense):                                                         
Other income                                382       265     1,890       265       366
Interest expense                             --      (134)     (162)     (342)     (294)
                                        -------   -------   -------   -------   -------
Income (loss) before provision 
  (benefit) for income taxes                292       375     4,167     2,139    (1,866)
Provision (benefit) for income taxes         10    (1,675)      127        50      ----
                                        -------   -------   -------   -------   -------
      Net income (loss)                 $   282   $ 2,050   $ 4,040   $ 2,089    (1,866)
                                        =======   =======   =======   =======   =======
Basic income (loss) per share           $   .04   $   .26   $   .52   $   .32   $  (.30)
                                        =======   =======   =======   =======   =======
Diluted income (loss) per share         $   .04   $   .26   $   .51   $   .32   $  (.30)
                                        =======   =======   =======   =======   =======
Weighted average shares outstanding       8,068     8,035     7,985     6,607     6,238
</TABLE>

<TABLE>
<CAPTION>
                                                         December 31,
                                       ------------------------------------------------
Balance Sheet Data:                      1998      1997      1996      1995      1994
------------------                     --------  --------  --------  --------  --------
<S>                                    <C>       <C>       <C>       <C>       <C>
Working Capital                         $15,051   $15,327   $15,892   $13,216   $ 5,053
Total assets                             29,493    29,017    28,398    24,880    16,862
Long-term obligations                        --        --        --       555       905
Stockholder's equity                    $27,352   $26,760   $24,440   $19,852   $11,602
</TABLE>

                                       24
<PAGE>
 
Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         -----------------------------------------------------------------------
         of Operations
         -------------

Overview

The Company's technology was developed primarily for defense and aerospace
applications, which have historically represented and continue to represent a
substantial portion of its business. Utilizing this historical base, the Company
has transitioned over several years to a more balanced product offering,
including industrial, consumer, microwave tube products, automotive,
semiconductor, and defense applications.

The Company's cost of product sales includes the cost of materials, direct labor
expenses and manufacturing overhead expenses.  The Company's business requires
that it maintain a relatively high fixed manufacturing overhead.  As a result,
the Company's gross profit, in absolute dollars and as a percentage of net
sales, is greatly impacted by the Company's sales volume and the corresponding
absorption of fixed manufacturing overhead expenses.  Furthermore, due to the
customized nature of many of its products, the Company is frequently required to
devote resources to sustaining engineering expenses, which are also included in
cost of product sales and are generally expensed as incurred.

                                       25
<PAGE>
 
Results of Operations

The percentage relationships to net sales of certain income and expense items
for the three years ended December 31, 1998 are contained in the following
table.

<TABLE>
<CAPTION>
                                                       Year Ended December 31,
                                                     --------------------------
                                                      1998      1997      1996
                                                     ------    ------    ------ 
<S>                                                  <C>       <C>       <C>
Net Sales                                            100.00%   100.00%   100.00%
Cost of product sales                                 81.02     81.11     74.67
                                                     ------    ------    ------
  Gross Profit                                        18.98     18.89     25.33
                                                     ------    ------    ------
Operating Expenses:                               
  R&D                                                  1.30        --        --
  Selling                                              5.69      5.28      5.57
  General & Administration                            12.33     12.76     11.11
                                                     ------    ------    ------
                                                      19.32     18.04     16.68
                                                     ------    ------    ------
Income from operations                                 (.34)      .85      8.65
Other income (expenses):                          
  Other income                                         1.45       .93      6.69
  Interest expense                                       --       (47)     (.57)
                                                     ------    ------    ------
                                                       1.45       .46      6.12
                                                     ------    ------    ------
Income before provision (benefit) for income taxes     1.11      1.31     14.77
Provision (benefit) for income taxes                    .04     (5.83)      .45
                                                     ------    ------    ------
Net income                                             1.07%     7.14%    14.32%
                                                     ======    ======    ======
</TABLE>

                                       26
<PAGE>
 
Years Ended December 31, 1998 and 1997

Net Sales.  Net sales for the year ended December 31, 1998 were $26.3 million, a
decrease of $2.4 million, or 8.4%, compared to the prior year.  The decrease in
sales is primarily related to the Advanced Ceramics Operations in Costa Mesa,
California.  Lightweight armor sales decreased due to delays in new Government
production releases.  Wear resistant component sales decreased because of the
downturn in capital equipment shipments, and the low price of crude oil reduced
the demand for exploration components.  Orthodontic bracket sales decreased
because the Company's customer increased its inventory levels in 1997 due to the
introduction of the new "Clarity" orthodontic bracket, and reduced the level of
inventory in 1998 because of "just in time" inventory practices.  Structural
ceramics for semiconductor equipment decreased from the comparable prior year
net sales because of the world-wide downturn in the semiconductor industry.

The Company's Semicon Associates Division in Lexington, Kentucky posted a
decrease in net sales of approximately $.1 million from the prior comparable
period.  This was mainly caused by reduced demand for the first three quarters
of 1998 (as compared to the same period in the comparable prior year), for
dispenser cathodes and samarium cobalt permanent magnets.  However, for the 4th
Quarter 1998, demand for these products increased over the comparable prior
year's fourth quarter due to replacement parts procurement.

The Company's Thermo Materials Division in Scottdale, Georgia posted an increase
in net sales from the prior comparable period by approximately $.75 million.
The increase is due to missile radome shipments that are a result of the prior
year pilot production and an increase in fused silica ceramic components due to
an aggressive sales effort.  Also, and to a lessor extent, net sales increased
due to the purchase of the Masrock and Fusil Foam assets and business from
Harbison Refractories Company.  This was a small asset acquisition that the
Company completed in the 4th Quarter of 1998.

International sales have and continue to be an important part of the Company's
business, representing 16% of the Company's net sales for the period ended
December 31, 1998.  This compares to 20% of net sales in the comparable prior
year period.  The decrease was mainly attributable to the Asian downward
economic trend in the current year.

Gross Profit.  The Company's gross profit was $5.0 million, or 19.0% of net
sales, for the year ended December 31, 1998, compared to $5.4 million, or 18.9%
of net sales, for the comparable prior year. The decrease in gross profit for
the year ended December 31, 1998 as compared to the prior year was $.4 million
or 8.0%.

All of the major product lines at the Company's Advanced Ceramics Operations in
Costa Mesa, California had decreases in gross profit as compared to the prior
year period due to lower volume and lower capacity utilization resulting in
unfavorable overhead absorption.  This resulted in a gross profit decrease of
$2.3 million as compared to the prior year.  Another key element that
contributed to the decrease was the charge of approximately $.3 million for
start-up costs associated with the semiconductor product line.

Gross profit for Semicon Associates in Lexington, Kentucky had an increase of
$1.8 million from the comparable prior year period.  The reason for the increase
was that in the prior year an adjustment of approximately $1.7 million to write
off inventory and to reduce inventory carrying amounts to net realizable values
was recorded.

                                       27
<PAGE>
 
Gross profit for Thermal Materials in Scottdale, Georgia increased approximately
$.4 million from the comparable prior year period.  The increase was the result
of increased volume, production yields, and greater capacity utilization.

Research and Development Expenses.  Research and development expenses were
approximately $.35 million for the year ended December 31, 1998.  The Company
established a new research and development department in 1998 to focus on new
materials technology.  The expenses incurred related to salaries, travel,
outside services, materials and small tools.

In addition, the Company historically has and continues to engage in application
engineering and internally-funded research to improve and reduce the cost of
production and to develop new products.  The costs associated with application
engineering and internally-funded research are generally expensed as incurred
and are included in cost of product sales.

Selling Expenses.  Selling expenses were $1.5 million for the year ended
December 31, 1998 and 1997.  Increases in direct salaries and travel expenses
were offset by a reduction in commission expense for the current year over the
prior comparable period.

General and Administrative Expenses.  General and administrative expenses were
$3.2 million for the year ended December 31, 1998, a $.4 million decrease from
the prior year.  The key elements for the decrease between the years was a non-
recurring charge in the prior year of $.2 million related to legal fees
associated with a legal settlement, coupled with a favorable settlement with a
customer in the current year resulting in net proceeds of $.4 million.  The
above decreases in expenses from the prior year were offset by a non-recurring
charge of $.2 million in the current year's 4th quarter.  This charge was the
result of written notification from the United States Environmental Protection
Agency that the Company was a responsible party in the Superfund cleanup of the
Casmalia Disposal Site in Santa Barbara County, CA.  The notification states
that Ceradyne, along with approximately 10,000 other parties, has been
designated as "de minimus" waste generator due to the relatively small
quantities of its waste disposal.  The Company properly disposed of this waste
material in the 1970's and 1980's, however the Casmalia Disposal Site leaked
into the water table.  Thus the waste generators must pay their share of the
cost of the cleanup effort.  The Company is investigating its insurance policies
for possible reimbursement of this charge.

Other Income and Expense.   Other income was approximately $.4 million for the
year ended December 31, 1998 compared to $.3 million for the prior year.  The
significant difference for the increase was the reduction of non-operational
miscellaneous expense that was incurred in the prior year.

Interest Expense.  The Company had no interest expense for the year ended
December 31, 1998.  The prior year had interest expense of $134,000.  The reason
for the decrease is the payment of all debt outstanding in the prior year.

Income Taxes.  The Company has recorded $10,000 provision for income tax for the
year ended December 31,1998.  The Company in the prior year reversed a portion
of the previously established valuation allowance, primarily related to net
operating losses from prior years to offset tax provisions at statutory rates.
The Company has approximately $12.4 million remaining in net operating loss
carryforwards for Federal income tax purposes.

                                       28
<PAGE>
 
Net Income.  Reflecting all of the matters discussed above, net income was
$282,000 (or $.04 per share basic and diluted) for the year ended December 31,
1998 compared to a net income of $2,050,000 (or $.26 per share basic and
diluted) for the prior year.

Years Ended December 31, 1997 and 1996.

Net Sales.  Net sales for the year ending December 31, 1997 were $28.7 million,
a modest increase of $.5 million, or 1.7%, compared to the prior year.  Key
elements of the 1997 product mix compared to 1996 reflects the following:
Structural ceramics for semiconductor equipment, a virtually new product line,
increased from $.l million in 1996 to $2.3 million in 1997.  The introduction of
"Clarity" orthodontic ceramic brackets resulted in sales of $4.9 million in
1997, a 118% increase over 1996.  This increase was due to increasing product
acceptance by orthodontists and the requirement by Ceradyne's customer, Unitek
(a Division of 3M), to meet its inventory levels.  Armor sales decreased to $3.4
million in 1997 from $7.5 million in 1996 due to a decline in lightweight
ceramic armor vest shipments caused by the government's decision to not exercise
its option for $6.1 million, which lapsed in March 1997.  Sales of the company's
cathodes for use in television and related uses fell to $.25 million from $1.1
million in 1996.  Management believes that the potential for large scale
production of its cathodes for television and related applications may not
materialize in the near future, if at all.

International sales have and are expected to continue to be an important part of
the Company's business, representing 20% of the Company's net sales for the
period ending December 31, 1997, and is the same percentage as for the prior
year.  The decrease in international shipments for cathodes for television from
the Semicon Associates Division has been offset by an increase of international
shipments for fused silica ceramics by the Thermo Materials Division.

Gross Profit.  The Company's gross profit was $5.4 million, or 18.9% of net
sales, for the year ended December 31, 1997, compared to $7.1 million, or 25.3%
of net sales, for the year ended December 31, 1996.  The decrease in gross
profit for the year ended December 31, 1997 as compared to the prior year was
$1.7 million or 24.2%.  The major reason for the decrease in gross profit was an
adjustment of approximately $1.7 million to write off inventory and establish
inventory reserves related to product lines at Semicon Associates Division in
Kentucky.  Management has determined that obsolete inventory in the cathode
product line, and the CRT ceramic-impregnated dispenser cathode for television
applications, needs to be reserved in the amount of $.8 million.  Of this
amount, $.5 million relates to inventory related to a contract with a Korean
manufacturer and was due to a contract dispute.  Also, a write down of $.9
million resulting from net realizable value analyses was recorded in the cathode
product line.  The Company has shifted production among different product lines
and now buys certain assemblies, which were previously manufactured in house,
from outside sources.

Except for the above adjustments, the gross profit change was slight between the
2 years. The orthodontic ceramic product line had increased gross profit because
of a sales volume increase of over 118%, and better process yields over the
prior year.  The industrial product line also showed improvement in its process
yields over the prior year.  The above increases were offset by decreases in
gross profit by the semiconductor product line which experienced initial start
up costs and low production yields.  Also, the armor product line had a lower
profit margin in 1997 than in 1996 because of sales volume decreases which did
not absorb as much of the Company's fixed overhead as in the prior year.

                                       29
<PAGE>
 
Selling Expenses.  Selling expenses were $1.5 million for the year ended
December 31, 1997, a decrease of $56,000 from the comparable period of the prior
year.  This decrease was primarily due to reduced commission expense.

General and Administrative Expenses.  General and Administrative Expenses were
$3.6 million for the year ended December 31, 1997, a $483,000  increase from the
comparable period of the prior year.  The increases were primarily due to  legal
fees associated with a litigation settlement, and to a write off of an account
receivable from a Far East customer.

Other Income and Expense.  Other income was $265,000 for the year ended December
31, 1997 compared to $1,890,000 for the year ended December 31, 1996.  The
decrease was mainly attributable to last year's reimbursement of $.2 million
from an insurance carrier for legal expenses, and a settlement with an insurance
carrier which netted approximately $1.3 million to the Company.

Interest Expense.  For the year ended December 31, 1997 interest expense was
$134,000, a 17.3% decrease over the comparable period of the prior year,
primarily attributable to a decrease in debt.

Income Taxes.  The Company, in conformance with its adopted Statement of
Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes", has
reversed a portion of the valuation allowance previously established applicable
to the net deferred tax asset.  The income tax benefit resulting from the
reversal results from the Company's recent history of profitable operations.
The Company has available net operating loss carryforwards of approximately
$11.6 million as of December 31, 1997 for federal income tax purposes.

Net Income.  Reflecting all of the matters discussed above, net income was
$2,050,000 (or $.26 per share) for the year ended December 31, 1997 compared to
a net income of $4,040,000 (or $.51 per share) for the prior year.

Year 2000 Disclosure.  Many currently installed computer systems and software
products are coded to accept only two digit entries in the date code field.
These date code fields will need to accept four digit entries to distinguish
21st century dates from 20th century dates.  This inability to recognize or
properly treat the Year 2000 may cause the company's systems and applications to
process critical financial and operational information incorrectly.  The Company
continues to assess the impact of the Year 2000 issue on its reporting systems
and operations.

The Company is currently in the process of investigating and determining whether
its internal accounting systems and other operational systems are Year 2000
compliant.  A new software system which is Year 2000 compliant was installed at
the Corporate Headquarters and its Advanced Ceramic Operations located in Costa
Mesa, California  in 1996.  The Company expects to complete the conversion of
its internal accounting system at its Kentucky and Georgia divisions to such
upgraded software in 1999.  The costs associated with these conversions are
approximately $150,000.  As of February 10, 1999, the conversion plans were
underway at the Kentucky and Georgia locations.  The estimated completion date
is set for May 1, 1999. The Company is taking steps to ensure that all of its
customers, suppliers, associates and affiliates will be in compliance with the
Year 2000 issue.  This process includes a questionnaire confirming the status of
compliance with the Year 2000 criteria set forth by the Company.  The criteria
that the Company will use to determine compliance with the Year 2000 is the
accurate processing of date/time information from, into, and between the
twentieth and twentieth-first centuries, and the years 1999 and 2000, including
leap year calculations that will affect the processing of information,
scheduling, manufacturing, and the quality of all products.  Also, the Company
is in 

                                       30
<PAGE>
 
the process of developing a contingency plan to minimize the risks associated
with non Year 2000 readiness. This plan is to be completed by 3rd Quarter 1999.

The Company is exposed to the following worst case Year 2000 scenario: That
several of the Company's customers and suppliers may experience Year 2000 non-
compliance issues that affect the Company.  However, as the Company does have a
wide customer base, and no sole source suppliers, it believes the non-compliance
issue to be minimal.  However, there can be no assurance that certain of the
Company's internal computer systems or networks or those of its key vendors and
customers will not be adversely affected by such Year 2000 issues, which could
have a material adverse effect on the Company's business, operating results or
financial condition.

Liquidity and Capital Resources

The Company generally meets its operating and capital requirements for cash flow
from operating activities and borrowings under its credit facility.

In November, 1997 the Company entered into a revolving credit agreement with
Comerica Bank.  The new credit facility amount remains at $4,000,000 as of year
ended December 31, 1998 and no collateral is required of the Company.  As of
December 31, 1998 there had been no borrowing under the credit facility.

Management believes that its current cash and cash equivalents on hand, as well
as cash generated from operations and the ability to borrow under the existing
credit facility, will be sufficient to finance anticipated capital and operating
requirements for at least the next 12 months.

Item 7A. Quantitative and Qualitative Disclosure About Market Risk
         ---------------------------------------------------------

SEC Regulation S-K, Rule 3-05 requires expanded disclosure related to market
risk.  The company as of year ended December 31, 1998 has no debt borrowing and
does not intend to borrow in the next twelve months.  However, the Company does
have assets in cash and cash equivalents, and changes in interest rates would
affect earnings on these assets.  As of December 31,1998, the Company had $2.9
million in a money market account based upon U.S. Treasury Bonds.  The interest
on this cash has earned 5.40% APR for year ended December 31, 1998, and this
interest has been recorded in the Company's financial statements as part of
other income in the amount of $175,000.  If the interest rate were to decrease
by 10% to 4.86% APR, the effect on other income and cash flow would result in
decreases of approximately $18,000.

Item 8.  Consolidated Financial Statements and Supplementary Data
         --------------------------------------------------------

The Consolidated Financial Statements and Supplementary Data commence at page 46
of this report and an index thereto in included in Part IV, Item 14 of this
report.

Item 9.  Changes in and Disagreements with Accountants on Accounting and
         ---------------------------------------------------------------
         Financial Disclosure
         --------------------

Not applicable

                                       31
<PAGE>
 
                                    PART III

 
Item 10.  Directors and Executive Officers of Registrant
          ----------------------------------------------

     Information regarding executive officers of the Company is included in Part
I of this report.

  The Directors of the Company are as follows:

<TABLE>
<CAPTION>
         Name               Age                  Position
----------------------   ---------   ------------------------------------
<S>                      <C>         <C>
Joel P. Moskowitz.....      59       Chairman of the Board, President and
                                     Chief Executive Officer
Leonard M. Allenstein.      60       Director
Richard A. Alliegro...      68       Director
Peter Beardmore.......      62       Director
Frank Edelstein.......      73       Director
Milton L. Lohr........      73       Director
Melvin A. Shader......      73       Director
</TABLE>

  Joel P. Moskowitz co-founded the Company's predecessor in 1967. He served as
President of the Company from 1974 until January 1987, and from September 1987
to the present. Mr. Moskowitz currently serves as Chairman of the Board and
Chief Executive Officer of the Company, which positions he has held since 1983.
Mr. Moskowitz currently serves on the Board of Trustees of Alfred University.
Mr. Moskowitz obtained a B.S. in Ceramic Engineering from Alfred University in
1961 and an M.B.A. from the University of Southern California in 1966.

  Leonard M. Allenstein has served on the Board of Directors of the Company
since 1983. Mr. Allenstein has been a private investor and businessman for more
than the past five years.  Mr. Allenstein was a founder and general partner of
Bristol Restaurants, which owns and operates restaurants in the Southern
California area, from 1978 until December 1986.

  Richard A. Alliegro has served on the Board of Directors of the Company since
1992.  Mr. Alliegro retired from Norton Company in 1990 after 33 years, where
his last position was Vice President, Refractories and Wear, for Norton's
Advanced Ceramics operation.  He served as President of Lanxide Manufacturing
Co., a subsidiary of Lanxide Corporation, from May 1990 to February 1993.  Mr.
Alliegro currently is the owner of AllTec Consulting, Inc., a ceramic technology
consulting firm.  Mr. Alliegro obtained B.S. and M.S. degrees in Ceramic
Engineering from Alfred University in 1951 and 1952, respectively, and serves as
a member of the Board of Trustees of that university.

  Dr. Peter Beardmore is the director of the Chemical and Physical Sciences
Laboratory of Ford Motor Company.  He has been associated with Ford since 1966.
Dr. Beardmore has a B. MET. in Metallurgy from the University of Sheffield, and
a Ph.D. in Metallurgy from the University of Liverpool.  Dr. Beardmore was
elected to the Board of Directors of the Company in 1996.

                                       32
<PAGE>
 
  Frank Edelstein has served on the Board of Directors of the Company since
1984.  Mr. Edelstein has been a Vice President of Gordon + Morris Group (a
spinoff of Kelso & Company), an investment banking firm, since November 1986.
From 1979 to November 1986, he was Chairman of the Board of International
Central Bank & Trust Company, which was acquired by Continental Insurance Co. in
July 1983.  Mr. Edelstein is currently a director of Arkansas Best Corp. and
IHOP Corp.

  Milton L. Lohr served as a director of the Company from 1986 until October
1988, when he resigned to accept a position as Deputy Undersecretary of Defense
for Acquisitions.  He held that position until May 1989 and was re-elected as a
director of the Company in July 1989.  Mr. Lohr is currently the President of
Defense Development Corporation, a defense-related research and development
company.  Mr. Lohr previously held the position of Senior Vice President of
Titan Systems, a defense-related research and development company, from 1986 to
1988, and was founder and President of Defense Research Corporation, a defense
consulting firm, from 1983 to 1986.  Mr. Lohr served from 1969 to 1983 as
Executive Vice-President of Flight Systems, Inc., a firm engaged in aerospace
and electronic warfare systems.  Mr. Lohr has over thirty-five years experience
in government positions and aerospace and defense management.  He currently
serves as a panel member of the President's Science Advisory Committee, a member
of the Office of the Secretary of Defense, Army Science Board, as well as other
ad hoc government related assignments.

  Melvin A. Shader has served on the Board of Directors of the Company since
1984. Dr. Shader retired in 1991 from TRW, Inc., where he was Vice President,
Business Development and Vice President, International at the Space and Defense
Sector of TRW, Inc.  Dr. Shader had been with TRW, Inc. since 1970.  From 1969
to 1970, Dr. Shader was Director of Planning in the Information Network Division
of Computer Sciences Corp.   From 1954 to 1968, he was an executive with
International Business Machines Corp.

Directors are elected annually and hold office until the next annual meeting of
stockholders and until their successors have been elected and qualified.  The
Company has agreed to nominate a representative of Ford for election as a
director pursuant to an agreement made in March 1986, pursuant to which
agreement Ford acquired a total of 1,207,299 shares of the Company's Common
Stock.  Joel P. Moskowitz and members of his family have agreed to vote a
portion of their shares of the Company's Common Stock, if necessary, for the
election of Ford's nominee.  Dr. Peter Beardmore is Ford's current
representative.  Officers serve at the discretion of the Board of Directors
except for Mr. Moskowitz, who serves pursuant to a five-year employment
agreement which expires in July 1999.

Compliance with Section 16(a) of the Securities Exchange Act of 1934

     Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
directors and executive officers, and persons who own more than ten percent of a
registered class of the Company's equity securities, to file with the Securities
and Exchange Commission ("SEC") initial reports of ownership and reports of
changes in ownership of Common Stock and other equity securities of the Company.
Officers, directors and greater than ten percent shareholders are required by
SEC regulations to furnish the Company with copies of all Section 16(a) forms
they file.

     To the Company's knowledge, based solely on a review of the copies of such
reports furnished to the Company and written representations that no other
reports were required during the fiscal year ended December 31, 1998, its
officers, directors and greater than ten percent beneficial owners complied with
all Section 16(a) filing requirements.

                                       33
<PAGE>
 
Item 11.  Executive Compensation
          ----------------------

Summary Compensation Table
--------------------------

          The following table shows certain information concerning the
compensation of the Chief Executive Officer and five other most highly
compensated executive officers of the Company whose aggregate compensation for
services in all capacities rendered during the year ended December 31, 1998
exceeded $100,000 (collectively, the "Named Executive Officers"):

<TABLE>
<CAPTION>
                                                                               Long Term               
                                                                               Compensation             
                                                                         ------------------------
                                  Annual Compensation                          Securities              
                         ---------------------------------------               Underlying
Name &                                                                         Options
Principal Position         Year        Salary          Bonus                   (# of Shares)
----------------------   --------   ------------   -------------         ------------------------
<S>                      <C>        <C>            <C>                   <C>
Joel P. Moskowitz            1998       $228,191         $ 2,920                           -
Chairman of the              1997        212,988          19,976                           -
 Board, Chief                1996        196,145          35,584                           -
 Executive Officer                                             -                   
 and President                                                                     
                                                                                   
David P. Reed                1998       $121,295               -                      10,000
Vice President               1997        118,056         $24,594                      13,500
                             1996        109,734          26,566                           -
                                                                                   
Howard F. George             1998       $101,062               -                       5,000
Vice President               1997         94,300         $ 6,210                           -
                             1996         90,000           6,984                      25,000
                                                                                   
Earl E. Conabee              1998       $101,220               -                       4,000
Vice President               1997         96,731               -                       2,000
                             1996         93,144               -                           -
                                                                                   
Donald A. Kenagy             1998       $103,142               -                       4,000
Vice President               1997         98,411               -                       2,000
                             1996         94,384               -                           -
                                                                                   
Gerhart D. DeBoer(1)         1998       $102,270               -                       5,000
Vice President               1997         36,705               -                      20,000
</TABLE>

(1) Mr. DeBoer's employment with the Company commenced in September 1997.

                                       34
<PAGE>
 
Option Grants in Last Fiscal Year
---------------------------------

   The following table sets forth certain information concerning grants of
options to each of the Named Executive Officers during the year ended December
31, 1998.  In addition, in accordance with the rules and regulations of the
Securities and Exchange Commission, the following table sets forth the
hypothetical gains or "option spreads" that would exist for the options.  Such
gains are based on assumed rates of annual compound stock appreciation of 5% and
10% from the date on which the options were granted over the full term of the
options.  The rates do not represent the Company's estimate or projection of
future Common Stock prices, and no assurance can be given that any appreciation
will occur or that the rates of annual compound stock appreciation assumed for
the purposes of the following table will be achieved.

<TABLE>
<CAPTION> 
                                                                                    Potential Realizable       
                                                                                  Value at Assumed Annual       
                                          Percent of                                Rates of Stock Price        
                                         Total Options                                Appreciation for          
                                          Granted to     Exercise                      Option Term(2)           
                      Options Granted    Employees in      Price     Expiration   -----------------------
Name                  (# of Shares)(1)    Fiscal Year    ($/Share)      Date        5%($)         10%($) 
----                  ----------------   -------------   ---------   ----------   ---------     ---------
<S>                   <C>                <C>             <C>         <C>          <C>            <C>
Joel P. Moskowitz               -                -             -             -          -              -
David P. Reed               5,000              3.9%        3.781       1/27/08      1,895         30,145
                            5,000              3.9%        3.500       9/04/08      1,000         27,900
Howard F. George            5,000              3.9%        3.500       9/04/08      1,000         27,900
Earl E. Conabee             2,000              1.6%        5.813       3/10/08      7,314         18,534
                            2,000              1.6%        3.500       9/04/08      4,400         11,160
Donald A. Kenagy            2,000              1.6%        5.813       3/10/08      7,314         18,534
                            2,000              1.6%        3.500       9/04/08      4,400         11,160
Gerhart D. DeBoer           5,000              3.9%        3.781       1/27/05      7,695         17,945
</TABLE>
                                        
(1)  The per share exercise price of all options granted is the fair market
     value of the Company's Common Stock on the date of grant.  Options have a
     term of 10 years and become exercisable in five equal installments, each of
     which vests at the end of each year after the grant date, except for Mr.
     DeBoer, whose options have a term of seven years and become exercisable in
     two equal installments, each of which vests at the end of each year after
     the grant date.

(2)  The potential realizable value is calculated from the exercise price per
     share, assuming the market price of the Company's Common Stock appreciates
     in value at the stated percentage rate from the date of grant to the
     expiration date.  Actual gains, if any, are dependent on the future market
     price of the Common Stock.

                                       35
<PAGE>
 
Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option
--------------------------------------------------------------------------
Values
------

     The following table sets forth certain information regarding option
exercises during the year ended December 31, 1998 by the Named Executive
Officers, the number of shares covered by both exercisable and unexercisable
options as of December 31, 1998 and the value of unexercised in-the-money
options held by the Named Executive Officers as of December 31, 1998:

<TABLE>
<CAPTION>
                                                                                           Value of Unexercised
                                                    Number of Securities Underlying       In-the-Money Options at
                                                 Unexercised Options at Fiscal Year-End     Fiscal Year-End(1)
                                                 --------------------------------------   -----------------------
                      No. of Shares
                       Acquired on     Value                         
       Name             Exercise      Realized      Exercisable        Unexercisable     Exercisable        Unexercisable 
       -----          -------------   --------      -----------        -------------     -----------        ------------- 
<S>                   <C>             <C>           <C>                <C>               <C>                <C>
Joel P. Moskowitz             -             -               -                   -                -                   -
David P. Reed             7,000       $19,250          33,200              24,800          $38,125              $3,375
Howard F. George              -             -          15,000              15,000                -                   -
Earl E. Conabee           5,000        13,750           3,400               5,600            2,625                   -
Donald A. Kenagy         10,000        27,500           4,400               6,600            6,500               1,875
Gerhart D. DeBoer             -             -          10,000              15,000                -                   -
</TABLE>

(1)  Based upon the closing price of the Common Stock on December 31, 1998, as
     reported by the Nasdaq National Market ($3.625 per share).

                                       36
<PAGE>
 
Employment Agreement
--------------------

  In July 1994, the Company entered into a five-year employment agreement with
Mr. Moskowitz, pursuant to which he will serve as Chairman of the Board of
Directors, Chief Executive Officer and President of the Company.  The agreement
provides for a base salary at the rate of $175,000 per year; however, Mr.
Moskowitz voluntarily agreed to accept a reduced salary at the rate of $150,000
per year through March 31, 1995 to aid the Company in its cost-cutting efforts.
His annual base salary was reinstated to $175,000 as of April 1, 1995, and was
increased to $200,000 effective February 12, 1996.  Effective February 10, 1997,
Mr. Moskowitz' base annual salary was increased to $215,000, and was further
increased to $230,000 effective February, 1998.  Effective February 9, 1999, the
annual base salary was further increased to $242,000. Under the agreement, if
Mr. Moskowitz' employment is terminated by the Company (other than as a result
of death, incapacity or for "good cause" as defined in the agreement) or if Mr.
Moskowitz elects to resign for "good reason" (as defined in the agreement), Mr.
Moskowitz will be entitled to receive severance pay in an amount equal to his
annual base salary, at the rate in effect on the date of termination, payable on
normal pay dates for the remainder of the term of the agreement.  "Good reason"
includes a "change in control" of the Company, a removal of Mr. Moskowitz from
any of his current positions with the Company without his consent, or a material
change in Mr. Moskowitz' duties, responsibilities or status without his consent.
A "change in control" of the Company shall be deemed to occur if (1) there is a
consolidation or merger of the Company where the Company is not the surviving
corporation and the shareholders prior to such transaction do not continue to
own at least 80% of the common stock of the surviving corporation, (2) there is
a sale of all, or substantially all, of the assets of the Company, (3) the
stockholders approve a plan for the liquidation or dissolution of the Company,
(4) any person becomes the beneficial owner, directly or indirectly, of 30% or
more of the Company's outstanding Common Stock or (5) if specified changes in
the composition of the Company's Board of Directors occur.

Compensation of Directors
-------------------------

  Directors are paid fees for their services on the Board of Directors in such
amounts as are determined from time to time by the Board.  During 1998, a fee of
$500 per month plus $1000 for each Board meeting attended was paid to each non-
employee director other than the Ford representative, Dr. Beardmore, who did not
receive a fee.

Compensation Committee Interlocks and Insider Participation
-----------------------------------------------------------

  The Board of Directors has established Audit, Compensation and Stock Option
Committees.  The Compensation Committee's function is to review and make
recommendations to the Board regarding executive officers' compensation.  This
committee is composed of Messrs. Beardmore, Edelstein, Alliegro, Shader and
Lohr.  The Audit Committee meets with the Company's independent public
accountants to review the Company's financial condition and internal accounting
controls.  This committee is composed of Messrs. Edelstein, Beardmore, Shader
and Lohr.  The Stock Option Committee is composed of Mr. Moskowitz and Dr.
Beardmore.  This committee administers the Company's 1994 Stock Incentive Plan
and the 1995 Employee Stock Purchase Plan.  Dr. Beardmore is serving as Ford's
representative on the Board of Directors.

                                       37
<PAGE>
 
Item 12.   Security Ownership of Certain Beneficial Owners
           and Management
           ------------------------------------------------

  The following table sets forth information as of March 3, 1999, regarding the
beneficial ownership of the common stock of the Company by (i) each person or
group known by the Company to be the beneficial owner of more than 5% of the
outstanding shares of common stock, (ii) each of the directors of the Company,
(iii) each of the executive officers named in the Summary Compensation Table,
and (iv) all current executive officers and directors of the Company as a group.

       Name of                      Amount and Nature of          Percent
   Beneficial Owner                 Beneficial Ownership(1)       of Class
-------------------------------     -----------------------       --------
Joel P. Moskowitz                         1,163,110                 14.4%
3169 Redhill Avenue                                                
Costa Mesa, CA 92626                                               
                                                                   
Ford Motor Company                        1,207,299                 15.0%
The American Road                                                  
Dearborn, MI 48121                                                 
                                                                   
Dimensional Fund Advisors, Inc.             466,000  (2)             5.8%
1299 Ocean Ave., 11th Floor                                        
Santa Monica, CA 90401                                             
Leonard M. Allenstein                       110,000  (3)             1.4%
                                                                   
Richard A. Alliegro                          19,500  (4)               *      
                                                                   
Earl E. Conabee                              24,834  (5)               *
                                                                   
Dr. Peter Beardmore                               -                    -
                                                                   
Garhart D. DeBoer                            10,000  (6)               *       
                                                                               
Frank Edelstein                              40,400  (7)               *       
                                                                               
Donald A. Kenagy                             15,595  (8)               *       
                                                                               
Melvin A. Shader                             23,000  (9)               *       
                                                                               
Milton L. Lohr                               20,000 (10)               *       
                                                                               
David P. Reed                                53,667 (11)               *       
                                                                               
Howard F. George                             15,557 (12)               *       

                                       38
<PAGE>
 
All current executive                     1,495,663                 18.6%
officers and directors as a
group (12 persons above)

*    Less than 1%


(1)  Except as otherwise noted, the beneficial owners have sole voting and
     investment powers with respect to the shares indicated, subject to
     community property laws where applicable.

(2)  Based on information contained in a statement on Schedule 13G dated
     February 11, 1999, as filed with the Securities and Exchange Commission. As
     stated in such Schedule 13G, all shares are held on behalf of advisory
     clients of Dimensional Fund Advisors, Inc., which disclaims beneficial
     ownership of such shares.

(3)  Includes 20,000 shares subject to options held by Mr. Allenstein which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(4)  Includes 15,000 shares subject to options held by Mr. Alliegro which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(5)  Includes 3,400 shares subject to options held by Mr. Conabee which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(6)  Includes 10,000 shares subject to options held by Mr. DeBoer which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(7)  Includes 22,500 shares subject to options held by Mr. Edelstein which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(8)  Includes 14,800 shares subject to options held by Mr. Kenagy which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.

(9)  Includes 10,000 shares subject to options held or will become exercisable
     within 60 days of by Dr. Shader which are currently exercisable March 3,
     1999.

(10) Includes 20,000 shares subject to options held by Mr. Lohr which are
     currently exercisable or will become exercisable within 60 days of March 3,
     1999.
 
(11) Includes 34,200 shares subject to options held will become exercisable
     within 60 days of March by Mr. Reed which are currently exercisable or 3,
     1999.
 
(12) Includes 15,000 shares subject to options held or will become exercisable
     within 60 days of by Mr. George which are currently exercisable March 3,
     1999.

                                       39
<PAGE>
 
Item 13.  Certain Relationships and Related Transactions
          ----------------------------------------------

     On March 11, 1986, the Company sold 526,316 shares of its Common Stock to
Ford Motor Company ("Ford") at a price of $19.00 per share, for a total purchase
price of $10,000,000.  At the same time, the Company and Ford created a new
corporation, Ceradyne Advanced Products, Inc. ("CAPI"), and entered into
agreements involving a broad-based technology transfer, licensing and joint
development program.  Under the agreements, Ford contributed technology and a
portfolio of United States and foreign patents relating to technical ceramics to
CAPI in exchange for 80% of CAPI's capital stock, and Ceradyne acquired the
remaining 20% of CAPI in exchange for $200,000.  The technology and patents
contributed by Ford were developed in the Ford Research Laboratories over a 15-
year period.  Under the March 11, 1986 agreements, the Company was granted an
option to acquire Ford's 80% interest in CAPI in exchange for an additional
680,983 shares of Ceradyne Common Stock, which the Company exercised effective
February 12, 1988.  As a result, Ceradyne now owns 100% of CAPI and Ford owns a
total of 1,207,299 shares of the Company's Common Stock.  The Company and Ford
also entered into a joint development agreement which includes a commitment by
Ford to contribute up to $5,000,000, on a matching value basis with Ceradyne,
for the development by Ceradyne of technical ceramic products oriented towards
the automotive market.  Through December 31, 1998, Ford has contributed to the
Company, on a cost sharing basis, a total of $4.5 million in cash and equipment
under this joint development program.

     So long as Ford continues to own 5%, or more, of the Company's outstanding
common stock, Ceradyne has agreed to use its best efforts to cause one person
designated by Ford to be elected a member of the Ceradyne Board of Directors
and, under certain circumstances in the event the Company issues additional
shares of its Common Stock in a public or private transaction, to permit Ford to
purchase, at the same price and terms upon which sold by the Company in such
transaction, additional shares of Ceradyne Common Stock to enable Ford to
maintain its percentage ownership of the Company.

     In connection with the sale of stock to Ford, Joel P. Moskowitz, Chairman
of the Board, Chief Executive Officer and President of the Company, and members
of his immediate family agreed to vote shares of the Company's Common Stock
owned by them in favor of the election of Ford's nominee to the Board of
Directors.  However, they may first vote that number of shares that is necessary
to assure the election of Joel P. Moskowitz as a director of the Company, and
any shares that are not necessary to assure the election of Mr. Moskowitz and a
Ford nominee to the Board of Directors may be voted by them without restriction.

                                       40
<PAGE>
 
                                 PART IV

Item 14.   Exhibits, Financial Statement Schedules and Reports on Form 8-K
           ---------------------------------------------------------------

(a) List of documents filed as part of this report:

    (1) Financial Statements:                                           Page
        ---------------------                                           ----
 
      Report of Independent Public Accountants                          45
      Consolidated Balance Sheets at December 31, 1998 and 1997         46-47
      Consolidated Statements of Operations for                         48
        the Years Ended December 31, 1998, 1997 and 1996
      Consolidated Statements of Stockholders Equity for                49
        the Years Ended December 31, 1998, 1997, and 1996
      Consolidated Statements of Cash Flows for the Years ended         50-51
        December 31, 1998, 1997 and 1996
      Notes to Consolidated Financial Statements                        52-64
 
    (2) Financial Statement Schedules:
 
    Schedule VIII -- Valuation and Qualifying Accounts                  65

    All other schedules are omitted since the required information is not
    present or is not present in amounts sufficient to require submission of the
    schedule, or because the information required is included in the
    Consolidated Financial Statements and Notes thereto.

(b) The following reports on Form 8-K were filed during the last quarter of the
    fiscal year ended  December 31, 1998:
 
None
 
(c) List of Exhibits
 
  3.1    Certificate of Incorporation of the Registrant. Incorporated herein by
         reference to Exhibit 3.1 to the Registrant's Registrant Statement on
         Form 8-B.
 
  3.2    Bylaws of Registrant. Incorporated herein by reference to Exhibit 3.2
         to the Registrant's Form 10-Q Report for the period ended June 30,
         1996.
 
  3.3    Amendment to Bylaws of Registrant, adopted April 29, 1996. Incorporated
         herein by reference to Exhibit 3.3 to the Registrant's Form 10-Q Report
         for the period ended June 30, 1996.
                                    
  4.1    Form of Representatives' Common Stock Purchase Warrant. Incorporated
         herein by reference to Exhibit 4.1 to the Registrant's Registration
         Statement on Form S-1 (File No. 33-62345).

                                       41
<PAGE>
 
  10.1*    Ceradyne, Inc. 1983 Stock Option Plan as amended and restated.
           (Incorporated by reference from Exhibit 10.13 to the Company's
           Registration Statement on Form S-1 (File No. 2-99930) filed on
           September 25, 1985 (the "1985 S-1").
 
  10.2     Lease between Trico Rents and the Registrant dated March 23, 1984,
           covering premises located at 235 Paularino Avenue, Costa Mesa,
           California. Incorporated herein by reference to Exhibit 10.14 to the
           Registrant's Registration Statement on Form S-1 (File No. 2-90821).

  10.3     Lease covering premises located at 3169-A Red Hill Avenue, Costa
           Mesa, California dated October 28, 1985. Incorporated herein by
           reference to Exhibit 10.30 to the Registrant's Annual Report on Form
           10-K for the fiscal year ended December 31, 1985.

  10.4     Stock Sale Agreement between the Registrant and Ford Motor Company
           dated March 11, 1986. Incorporated herein by reference to Exhibit
           10.31 to the Registrant's Annual Report on Form 10-K for the fiscal
           year ended December 31, 1985.
                                                               
  10.5     Agreement between certain shareholders of the Registrant and Ford
           Motor Company dated March 11, 1986. Incorporated herein by reference
           to Exhibit 10.32 to the Registrant's Annual Report on Form 10-K for
           the year ended December 31, 1985.

  10.6     Stock Purchase Agreement between Ceradyne Advanced Products, Inc.,
           the Registrant and Ford Motor Company dated March 11, 1986.
           Incorporated herein by reference to Exhibit 10.33 to the Registrant's
           Annual Report on Form 10-K for the fiscal year ended December 31,
           1985.
 
  10.7     Patent and Technology Transfer Agreement between Ford Motor Company
           and Ceradyne Advanced Products, Inc. dated March 11, 1986.
           Incorporated herein by reference to Exhibit 10.34 to the Registrant's
           Annual Report on Form 10-K for the fiscal year ended December 31,
           1985.

  10.8     License Agreement between the Registrant and Ceradyne Advanced
           Products, Inc. dated March 11, 1986. Incorporated herein by reference
           to Exhibit 10.35 to the Registrant's Annual Report on Form 10-K for
           the fiscal year ended December 31, 1985.

  10.9     License Agreement between Ford Motor Company and the Registrant dated
           March 11, 1986. Incorporated herein by reference to Exhibit 10.36 to
           the Registrant's Annual Report on Form 10-K for the fiscal year ended
           December 31, 1985.

  10.10    Joint Development Agreement between the Registrant and Ford Motor
           Company dated March 11, 1986. Incorporated herein by reference to
           Exhibit 10.37 to the Registrant's Annual Report on Form 10-K for the
           fiscal year ended December 31, 1985.

  10.11    Lease dated March 31, 1986 covering premises located at 3163 Red Hill
           Avenue, Costa Mesa, California. Incorporated herein by reference to
           Exhibit 10.45 to the Registrant's Annual Report on Form 10-K for the
           fiscal year ended December 31, 1986.

                                       42
<PAGE>
 
  10.12    Lease dated August 5, 1986 covering premises located at 225 Paularino
           Avenue, Costa Mesa, California. Incorporated herein by reference to
           Exhibit 10.46 to the Registrant's Annual Report on Form 10-K for the
           fiscal year ended December 31, 1986.

  10.13    Short-form Memorandum of Lease Assignment dated December 15, 1986,
           and Lease dated June 23, 1980, covering premises located at 3449
           Church Street, Scottdale, Georgia. Incorporated herein by reference
           to Exhibit 10.47 to the Registrant's Annual Report on Form 10-K for
           the fiscal year ended December 31, 1986.
 
  10.14*   Amendment dated June 3, 1986 to the Ceradyne, Inc. 1983 Stock Option
           Plan. Incorporated herein by reference to Exhibit 10.50 to the
           Registrant's Annual Report on Form 10-K for the fiscal year ended
           December 31, 1986.

  10.15*   Amendment dated March 16, 1987 to the Ceradyne, Inc. 1983 Stock
           Option Plan. Incorporated herein by reference to Exhibit 10.51 to the
           Registrant's Annual Report on Form 10-K for the fiscal year ended
           December 31, 1986.

  10.16    Joint Development Agreement dated March 28, 1986 between Unitek
           Corporation and the Registrant, and First and Second Amendments
           thereto. Incorporated herein by reference to Exhibit 10.52 to the
           Registrant's Annual Report on Form 10-K for the fiscal year ended
           December 31, 1986.

  10.17*   Amendment dated April 30, 1987 to the Ceradyne, Inc. 1983 Stock
           Option Plan. Incorporated herein by reference to Exhibit 10.56 to the
           Registrant's Registration Statement on Form 8-B.

  10.18*   Employment Agreement entered into as of July 5, 1994 by and between
           Joel P. Moskowitz and the Registrant. Incorporated herein by
           reference to Exhibit 10.30 to the Registrant's Annual Report on Form
           10-K for the fiscal year ended December 31, 1994.
 
  10.19*   Ceradyne, Inc. 1994 Stock Incentive Plan. Incorporated herein by
           reference to Exhibit 10.31 to the Registrant's Annual Report on Form
           10-K for the fiscal year ended December 31, 1994.
                                                              
  10.20*   Amendment No. 1 to the Ceradyne, Inc. 1994 Stock Incentive Plan.
           Incorporated herein by reference to Exhibit 4.2 to Registrant's
           Registration Statement on Form S-8 (File No. 33-61675).

  10.21*   Ceradyne, Inc. 1995 Employee Stock Purchase Plan. Incorporated herein
           by reference to Exhibit 4.1 to Registrant's Registration Statement on
           Form S-8 (File No. 33-61677).

  10.22    Amendment No. 2, dated June 5, 1995, to Lease between Trico Rents and
           the Registrant covering premises located at 235 Paularino Avenue,
           Costa Mesa, California. Incorporated herein by reference to Exhibit
           10.32 to the Registrant's Registration Statement on Form S-1 (File
           No. 33-62345).

                                       43
<PAGE>
 
  10.23    Amendment No. 2, dated June 5, 1995, to Lease covering premises
           located at 3169-A Red Hill Avenue, Costa Mesa, California.
           Incorporated herein by reference to Exhibit 10.33 to the Registrant's
           Registration Statement on Form S-1 (File No. 33-62345).

  10.24    Amendment No. 2, dated June 5, 1995, to Lease dated March 31, 1986
           covering premises located at 3163 Red Hill Avenue, Costa Mesa,
           California. Incorporated herein by reference to Exhibit 10.34 to the
           Registrant's Registration Statement on Form S-1 (File No. 33-62345).

  10.25    Amendment No. 2, dated June 5, 1995, to Lease dated August 5, 1986
           covering premises located at 225 Paularino Avenue, Costa Mesa,
           California. Incorporated herein by reference to Exhibit 10.35 to the
           Registrant's Registration Statement on Form S-1 (File No. 33-62345).
 
  10.26*   Amendment No. 2 to the Ceradyne, Inc. 1994 Stock Incentive Plan
           incorporated herein by reference to Exhibit 10.36 to the Registrant's
           Annual report on Form 10-K for the fiscal year ended December 31,
           1996.

  10.27*   Amendment No. 3 to the Ceradyne, Inc. 1994 Stock Incentive Plan.
           Incorporated herein by reference to Exhibit 4.4 to Registrant's
           Registration Statement on Form S-8 (File No. 333-31679).

  10.28*   Amendment No. 4 to the Ceradyne, Inc. 1994 Stock Incentive Plan.
 
  21.1     Subsidiaries of the Registrant. Incorporated herein by reference to
           Exhibit 23.2 to the Registrant's Statement on Form S-1 (File No. 33-
           62345).

  23.1     Consent of Arthur Andersen LLP.

  27.1     Financial Data Schedule.

  *        Each of these exhibits constitutes a management contract,
           compensatory plan, or arrangement required to be filed as an exhibit
           to this Report pursuant to Item 14(c) of this Report.

                                       44
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Stockholders and Directors of
  Ceradyne, Inc.:

  We have audited the accompanying consolidated balance sheets of Ceradyne, Inc.
(a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997, and
the related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Ceradyne, Inc. and subsidiaries
as of December 31, 1998 and 1997, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 1998, in
conformity with generally accepted accounting principles.

Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index of
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not a required part of the basic
financial statements. This schedule has been subjected to the auditing
procedures applied in our audits of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

                                           /s/ ARTHUR ANDERSEN LLP
                                           ARTHUR ANDERSEN LLP

Orange County, California
March 5, 1999

                                       45
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------

                          DECEMBER 31, 1998 AND 1997
                          --------------------------
 
                                    ASSETS
                                    ------
                            (Amounts in thousands)
<TABLE> 
<CAPTION> 
                                                               1998      1997
                                                              -------   -------
<S>                                                           <C>       <C> 
CURRENT ASSETS:
 Cash and cash equivalents                                    $ 2,870   $ 3,569
 Accounts receivable, net of allowances of
  approximately $92 and $179 for doubtful
  accounts in 1998 and 1997, respectively                       4,381     4,685
 Other receivables                                                167        96
 Inventories                                                    7,520     7,366
 Production tooling                                             1,104       882
 Prepaid expenses and other                                       880       716
                                                              -------   -------
   Total current assets                                        16,922    17,314
                                                              -------   -------
 
 
PROPERTY, PLANT AND EQUIPMENT:
 Land                                                             422       422
 Buildings and improvements                                     1,825     1,825
 Machinery and equipment                                       20,664    18,456
 Leasehold improvements                                         1,723     1,629
 Office equipment                                               2,210     2,001
 Construction in progress                                         103       401
                                                              -------   -------
                                                               26,947    24,734
  Less--Accumulated depreciation and amortization              18,090    16,768
                                                              -------   -------
                                                                8,857     7,966
                                                              -------   -------
COSTS IN EXCESS OF NET ASSETS ACQUIRED,
 net of accumulated amortization of $1,908 and $1,751 in
 1998 and 1997, respectively                                    2,009     1,923
                                                              -------   -------
 
OTHER ASSETS, net of accumulated amortization of
 $618 and $592 in 1998 and 1997, respectively                   1,705     1,814
                                                              -------   -------
 
   Total assets                                               $29,493   $29,017
                                                              =======   =======
 
</TABLE>

                  The accompanying notes are an integral part
                     of these consolidated balance sheets.

                                       46
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------
                                        
                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                                        
                           DECEMBER 31, 1998 AND 1997
                           --------------------------
                                        
                      LIABILITIES AND STOCKHOLDERS' EQUITY
                      ------------------------------------
                   (Amounts in thousands, except share data)
<TABLE>
<CAPTION>
 
                                                            1998        1997
                                                          --------    --------
<S>                                                       <C>         <C>
CURRENT LIABILITIES:
  Accounts payable                                        $  1,084    $  1,197
  Accrued expenses:
    Payroll and payroll related                                553         622
    Other                                                      234         168
                                                          --------    --------
          Total current liabilities                          1,871       1,987
                                                          --------    --------
 
DEFERRED REVENUE                                               270         270
                                                          --------    --------
 
COMMITMENTS AND CONTINGENCIES
 
STOCKHOLDERS' EQUITY
  Common stock, $.01 par value:
    Authorized--12,000,000 shares
    Outstanding--8,054,838 and 7,963,459 shares
     in 1998 and 1997, respectively                         37,718      37,408
    Accumulated deficit                                    (10,366)    (10,648)
                                                          --------    --------
 
      Total stockholders' equity                            27,352      26,760
                                                          --------    --------
 
      Total liabilities and stockholders' equity          $ 29,493    $ 29,017
                                                          ========    ========
 
</TABLE>


                  The accompanying notes are an integral part
                     of these consolidated balance sheets.

                                       47
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     -------------------------------------
                                        
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
              ----------------------------------------------------
                 (Amounts in thousands, except per share data)
<TABLE>
<CAPTION>
 
                                            1998       1997       1996
                                           -------    -------    -------
<S>                                        <C>        <C>        <C>
NET SALES                                  $26,279    $28,693    $28,212
 
COST OF PRODUCT SALES                       21,292     23,274     21,065
                                           -------    -------    -------
 
   Gross profit                              4,987      5,419      7,147
                                           -------    -------    -------
 
OPERATING EXPENSES:
 Selling                                     1,494      1,515      1,571
 General and administrative                  3,239      3,660      3,137
 Research and development                      344        ---        ---
                                           -------    -------    -------
                                                                        
                                             5,077      5,175      4,708
                                           -------    -------    -------
                                                                        
   Income from operations                      (90)       244      2,439
                                           -------    -------    -------
                                                                        
OTHER INCOME (EXPENSE):                                                 
 Other income                                  382        265      1,890
 Interest expense                              ---       (134)      (162)
                                           -------    -------    -------
                                               382        131      1,728
                                           -------    -------    -------
                                                                        
   Income before provision (benefit)                                    
   for income taxes                            292        375      4,167
                                                                        
PROVISION (BENEFIT) FOR INCOME                                          
  TAXES                                         10     (1,675)       127
                                           -------    -------    -------
                                                                        
   Net income                              $   282    $ 2,050    $ 4,040
                                           =======    =======    =======
                                                                        
BASIC INCOME PER SHARE                        $.04       $.26    $   .52
                                           =======    =======    =======
                                                                        
DILUTED INCOME PER SHARE                      $.04       $.26    $   .51
                                           =======    =======    ======= 
</TABLE>
                  The accompanying notes are an integral part
                       of these consolidated statements.

                                       48
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                ------------------------------------------------
                                        
             FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, and 1996
             -----------------------------------------------------
                   (Amounts in thousands, except share data)

<TABLE>
<CAPTION>
 
 
                                     Common Stock
                                 -------------------
                                  Number                Accumulated
                                 of Shares   Amount       Deficit
                                 ---------   -------   -------------
<S>                              <C>         <C>       <C>
 
BALANCE, December 31, 1995       7,715,624   $36,590       $(16,738)
 
  Issuance of common stock          25,521       147            ---
  Exercise of stock options        160,645       401            ---
  Net Income                           ---       ---          4,040
                                 ---------   -------       --------
 
BALANCE, December 31, 1996       7,901,790   $37,138       $(12,698)
 
 
  Issuance of common stock          37,469       202            ---
  Exercise of stock options         24,200        68            ---
  Net Income                           ---       ---          2,050
                                 ---------   -------       --------
 
BALANCE, December 31, 1997       7,963,459    37,408        (10,648)
 
  Issuance of common stock          50,179       197            ---
  Exercise of stock options         41,200       113            ---
  Net Income                           ---       ---            282
                                 ---------   -------       --------
BALANCE, December 31, 1998       8,054,838   $37,718       $(10,366)
                                 =========   =======       =========           
</TABLE> 


                  The accompanying notes are an integral part
                       of these consolidated statements.

                                       49
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------

              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
              ----------------------------------------------------
                             (Amounts in thousands)
<TABLE>
<CAPTION>
 
 
                                                            1998       1997       1996
                                                          --------   --------   --------
<S>                                                        <C>        <C>        <C>
 
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income                                               $   282    $ 2,050    $ 4,040 
  Adjustments to reconcile net income to net cash                                        
     provided by operating activities:                                                   
     Depreciation and amortization                           1,505      1,361      1,284 
                                                                                         
  Changes in operating assets and liabilities:                                           
     (Increase) decrease in accounts receivable, net           304        169     (1,095)
     (Increase) decrease in other receivables                  (71)     1,301     (1,385)
     (Increase) decrease in inventories                       (154)       390     (1,007)
     Increase in production tooling                           (222)      (344)      (172)
     Increase in prepaid expenses and other assets            (324)    (1,683)       (78)
     Increase (decrease) in accounts payable                  (113)      (465)        20 
     Increase (decrease) in accrued expenses                    (3)      (245)        66 
     Increase in deferred revenue                              ---          9        --- 
                                                           -------    -------    ------- 
                                                                                         
          Net cash provided by operating activities          1,204      2,543      1,673 
                                                           -------    -------    ------- 
                                                                                         
CASH FLOWS FROM INVESTING ACTIVITIES:                                                    
                                                                                         
  Purchases of property, plant and equipment                (2,213)    (2,887)    (2,641)
                                                           -------    -------    ------- 
                                                                                         
          Net cash used in investing activities             (2,213)    (2,887)    (2,641)
                                                           -------    -------    ------- 
 
</TABLE>
                  The accompanying notes are an integral part
                       of these consolidated statements.

                                       50
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                                     - 2 -
<TABLE>
<CAPTION>
 
                                                                    1998       1997       1996
                                                                   -------    -------    -------
<S>                                                                <C>        <C>        <C>
CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from issuance of common stock, net                      $   310    $   270    $   548
  Net payments on long-term debt                                       ---     (1,000)    (1,156)
                                                                   -------    -------    -------
    Net cash provided by (used in) financing activities                310       (730)      (608)
                                                                   -------    -------    -------
                                                                                                
Decrease in cash and cash equivalents                                 (699)    (1,074)    (1,576)
                                                                                                
  Cash and cash equivalents, beginning of period                     3,569      4,643      6,219
                                                                   -------    -------    -------
                                                                                                
  Cash and cash equivalents, end of period                         $ 2,870    $ 3,569    $ 4,643
                                                                   =======    =======    =======
                                                                                                
SUPPLEMENTAL DISCLOSURES OF CASH FLOW                                                           
  INFORMATION:                                                                                  
                                                                                                
  Interest paid                                                    $   ---    $   134    $   150
                                                                   =======    =======    =======
  Income taxes paid                                                $    10    $    33    $   177
                                                                   =======    =======    ======= 
 
</TABLE>

                  The accompanying notes are an integral part
                       of these consolidated statements.

                                       51
<PAGE>
 
                                 CERADYNE, INC.
                                 --------------

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   ------------------------------------------
                                        
                               DECEMBER 31, 1998
                               -----------------

1.  Summary of Significant Accounting Policies
    ------------------------------------------

    a.  Principles of Consolidation and Nature of Operations
    --------------------------------------------------------

    The consolidated financial statements include the financial statements of
    Ceradyne, Inc. (a Delaware Corporation), and its subsidiaries. Ceradyne,
    Inc. and its subsidiaries are collectively referred to herein as the
    Company. All significant intercompany accounts and transactions have been
    eliminated.

    The Company develops, manufactures and markets advanced technical ceramic
    products and components for industrial, defense, consumer and microwave
    applications. The products are sold primarily to industrial, consumer, and
    defense concerns globally.

    b.  Cash and Cash Equivalents
        -------------------------

    The Company considers all highly liquid investments with an initial maturity
    of three months or less when purchased to be cash equivalents.

    c.   Accounts Receivable
         -------------------

    The allowance for doubtful accounts includes management's estimate of the
    amount expected to be uncollectable on specific accounts and unidentified
    accounts included in accounts receivable. In estimating the potential losses
    on specific accounts, management relies on in-house prepared analysis and
    review of other available information. The amounts the Company will
    ultimately realize could differ from the amounts assumed in arriving at the
    allowance for doubtful accounts in the accompanying financial statements.

    d. Inventories
       -----------

    Inventories are valued at the lower of cost (first-in, first-out) or market.
    The write down of inventory for obsolete items is based on management's
    estimate of the amount considered obsolete based on specific reviews of
    inventory items. In estimating the allowance, management relies on its
    knowledge of the industry as well as its current inventory levels. The
    amounts the Company will ultimately realize could differ from amounts
    estimated by management. Inventory costs include the cost of material, labor
    and manufacturing overhead. The following is a summary of inventories by
    component:

<TABLE>
<CAPTION>
                                     December 31,
                               -------------------------
                                  1998           1997             
                                  ----           ----             
<S>                            <C>            <C>                
 Raw materials                 $4,098,000     $3,338,000         
 Work-in-process                2,413,000      3,617,000         
 Finished goods                 1,009,000        411,000         
                               ----------     ----------         
                               $7,520,000     $7,366,000                   
                               ==========     ==========          
</TABLE> 

                                       52
<PAGE>
 
e.  Property, Plant and Equipment
    -----------------------------

    Depreciation and amortization of property, plant and equipment are provided
    using the straight-line method over the following estimated useful lives:

          Buildings and improvements        20 years
          Machinery and equipment           3 to 12 years
          Leasehold improvements            Term of lease
          Office equipment                  5 years
 
    Maintenance, repairs and minor renewals are charged to expense as incurred.
    Repairs and maintenance expense approximated $729,000, $708,000, and
    $598,000 in 1998, 1997 and 1996, respectively. Additions and improvements
    are capitalized. When assets are disposed of, the applicable costs and
    accumulated depreciation and amortization are removed from the accounts and
    any resulting gain or loss is included in the results of operations.

    f.  Sales Recognition
        -----------------

    Sales are recorded as of the date shipments are made, or goods are accepted
    by customers for production contracts.

    g.  Deferred Revenue
        ----------------

    In September 1994, the Company finalized an agreement to manufacture and
    supply a specific cathode to a third party at reduced prices. In
    consideration for entering into this contract, the Company received a cash
    fee of $261,000. The fee was deferred in the financial statements and was
    recognized over the life of the agreement once shipments commence. At
    December 31, 1997, all of the fee has been recognized.

    In November 1997, Ford Motor Company contributed $270,000 for the year 1998
    to the Joint Product Development Program (see Note 10). The Company fully
    amortized this amount to revenue during 1998.

    In October 1998, Ford Motor Company contributed an additional $270,000 for
    the year 1999 to the Joint Product Development Program. The Company will
    fully amortize this amount to revenue during 1999.

    h.  Net Income Per Share
        --------------------

    The Company accounts for net income per share in accordance with SFAS No.
    128 "Earnings Per Share". Basic net income per share is computed by dividing
    income available to common stockholders by the weighted average number of
    common shares outstanding. Diluted net income per share is computed by
    dividing income available to common stockholders by the weighted average
    number of common shares outstanding plus the effect of any dilutive stock
    options and common stock warrants using the Treasury stock method.

                                       53
<PAGE>
 
  The following is a summary of the number of shares entering into the
  computation of net income per common and common equivalent share:

<TABLE>
<CAPTION>
                                                            December 31,
                                                  ---------------------------------
                                                    1998        1997        1996
                                                  ---------   ---------   ---------
<S>                                               <C>         <C>         <C>
     Weighted average number of
       shares outstanding                         8,005,000   7,931,000   7,807,000
     Dilutive stock options and 
       common stock warrants                         63,000     104,000     178,000
                                                  ---------   ---------   ---------
     Number of shares used in
       diluted computation                        8,068,000   8,035,000   7,985,000
                                                  =========   =========   =========
</TABLE>

  i.  Accounting for Long-Lived Assets
      --------------------------------

  As prescribed by Statement of Financial Accounting Standards (SFAS) No. 121,
  "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets
  to be Disposed of," the Company assesses the recoverability of its long-lived
  assets (including goodwill) by determining whether the asset balance can be
  recovered over the remaining depreciation or amortization period through
  projected undiscounted future cash flows.  Cash flow projections, although
  subject to a degree of uncertainty, are based on trends of historical
  performance and management's estimate of future performance, giving
  consideration to existing and anticipated competitive and economic conditions.
  There were no impairment charges in any of the three years in the period ended
  December 31, 1998.

  j.  Deferred Start-up and Preproduction Costs
      -----------------------------------------

  Start-up costs incurred to establish the technological feasibility of a new
  product to be sold or otherwise marketed are charged to expense in the period
  incurred.  Costs incurred subsequent to establishing technological feasibility
  but prior to commercial sales to customers are capitalized and amortized over
  one year from the startup completion date.   During the year ended December
  31, 1998, $252,000 of deferred startup costs from the semiconductor product
  line were expensed.  In 1998 the Company  incurred $188,000 in deferred costs
  capitalized for the armor vest product line under a new government contract.
  In September 1998, the Company received a commitment for the initial minimum
  quantity to be purchased.

  Statement of Position 98-5 "Reporting on the Costs of Start-up Activities" is
  effective for the Company's fiscal year beginning January 1, 1999.  The effect
  of adoption will be immaterial to the Company's financial position and results
  of operations.

  k.  Use of Estimates
      ----------------

  The preparation of financial statements in accordance with generally accepted
  accounting principles requires management to make estimates and assumptions
  that affect the reported amounts of assets and liabilities and disclosure of
  contingent assets and liabilities at the date of the financial statements.
  Actual results could differ from those estimates.

                                       54
<PAGE>
 
  l.  Engineering and Research
      ------------------------

  The costs associated with application engineering and internally-funded
  research are expensed as incurred and are included in cost of product sales or
  other operating expenses.  The Company established a new research and
  development department in 1998 to focus on new materials technology.  Costs
  associated with the department approximated $344,000.  In addition, the
  Company has historically and continues to engage in application engineering
  and internally funded research to improve and reduce the cost of products and
  to develop new products.  Costs associated with Company-funded research were
  approximately $384,000, $380,000 and $400,000 in 1998, 1997 and 1996,
  respectively.

  m.  Stock Based Compensation Plans
      ------------------------------

  Effective January 1, 1996, the Company adopted the disclosure provisions of
  SFAS No. 123, "Accounting for Stock-Based Compensation".  At a minimum, SFAS
  No. 123  requires the Company to disclose pro forma net income and earnings
  per share as if the fair value based accounting method of SFAS No. 123 had
  been used to account for stock-based compensation.  These disclosures are
  included in Note 7.

  n.  Fair Value of Financial Instruments
      ----------------------------------- 

  The carrying value of accounts receivable and trade payables approximates the
  fair value due to their short-term maturities.  The carrying value of the
  Company's line of credit is considered to approximate fair market value as the
  interest rates of these instruments are based predominately on variable
  reference rates.

  o.  Environmental Liabilities and Expenditures
      ------------------------------------------

  Accruals for environmental matters are recorded in operating expenses when it
  is probable that a liability has been incurred and the amount of the liability
  can be reasonably estimated.  In the 4th quarter of 1998, the Company recorded
  approximately $.2 million as an accrual for the written notification from the
  United States Environmental Protection Agency that the Company was a
  responsible party in the Superfund cleanup of the Casmalia Disposal Site in
  Santa Barbara County, CA.  The notification states that Ceradyne, along with
  approximately 10,000 other parties, have been designated as "de minimus" waste
  generators due to the relatively small quantities of their waste disposal.
  The Company properly disposed of this waste material in the 1970's and 1980's,
  however the Casmalia Disposal Site leaked into the water table.  Thus the
  waste generators must pay their share of the cost of the cleanup effort.  The
  company is investigating its insurance policies for possible reimbursement of
  this charge.

2. Debt and Bank Borrowing Arrangements
   ------------------------------------

In November, 1997 the Company terminated its revolving credit agreement with an
asset based lender, and entered into a revolving credit agreement with Comerica
Bank.  The new credit facility amount remains at $4,000,000 and no collateral
will be required of the Company.  The Company paid off its short-term minimum
borrowing requirement debt of $1,000,000 in fiscal year 1997.  As of December
31, 1998 there had been no borrowing under the credit facility.

                                       55
<PAGE>
 
3.  Income Taxes
    ------------

The provision (benefit) for income taxes is comprised of the following:

<TABLE>
<CAPTION>
                                1998       1997      1996
                              --------   --------   -------
<S>                           <C>        <C>        <C>
 
    Current                    $    10    $    33   $   127
    Deferred                        --     (1,708)       --
                               -------    -------   -------
                               $    10    $(1,675)  $   127
                               =======    =======   =======
</TABLE>

The Company's deferred tax asset at December 31, 1998 relates primarily to its
tax net operating loss carryforwards, which total approximately $12.4 million
and expire as follows:
<TABLE>
<CAPTION>
 
<S>                                                <C>
                     2003                          $ 2,242,000
                     2004                            3,015,000
                     2005                              161,000
                     2006                              218,000
                     2007                            1,093,000
                     2008                            2,050,000
                     2009                            1,828,000
                     2012                            1,620,000
                     2018                              177,000
                                                   -----------
                                                   $12,404,000
                                                   =========== 
</TABLE> 
 
The components of the Company's deferred tax asset as of December 31, 1998 and
1997 are as follows:

<TABLE> 
<CAPTION> 
                                                       December 31,         
                                                --------------------------  
                                                    1998           1997     
                                                -----------    -----------  
<S>                                             <C>            <C>  
          Inventory adjustments                 $   246,000    $   583,000  
          Contingency reserves                       71,000            ---  
          Deferred revenue                              ---        108,000  
          Vacation accrual                           91,000        112,000  
          Bad debt allowance                         36,000         72,000  
          Net operating loss and tax credit                                 
           carryforwards                          4,961,000      4,630,000  
          Other                                     (81,000)       (83,000) 
                                                -----------    -----------  
                                                  5,324,000      5,422,000  
          Valuation allowance                    (3,699,000)    (3,714,000) 
                                                -----------    -----------
            Net deferred tax asset              $ 1,625,000    $ 1,708,000  
                                                ===========    ===========   
</TABLE>

Management believes it is more likely than not that the results of future
operations will generate sufficient taxable income to realize the deferred tax
asset as reduced by the valuation allowance.

                                       56
<PAGE>
 
The effective income tax rate for the years ended December 31, 1998, 1997 and
1996 differs from the Federal statutory income tax rate due to the following
items:
<TABLE>
<CAPTION>
 
                                                                              December 31
                                                               -----------------------------------------
                                                                 1998            1997          1996
                                                               --------      -----------    -----------
<S>                                                            <C>         <C>              <C>
       Income before taxes                                     $292,000      $   375,000    $ 4,167,000
                                                               --------      -----------    -----------
       Provision for income taxes at federal
       statutory rate                                           113,000          128,000      1,417,000
       Increases (decreases) in tax resulting from:
          Utilization of net operating loss carryforwards       (57,000)         (95,000)    (1,389,000)
          Reduction of valuation allowance                          ---       (1,846,000)           ---
          Other, including state taxes                          (46,000)         138,000         99,000
                                                               --------      -----------    -----------
       Provision (benefit) for income taxes                      10,000       (1,675,000)       127,000
                                                               --------      -----------    -----------
       Effective tax rate                                          3.47%         (446.67)%         3.05%
                                                               ========      ===========    ===========
</TABLE>

4. Commitments and Contingencies
   -----------------------------
   a.  Operating Lease Obligations
       ---------------------------

   The Company leases certain of its manufacturing facilities under
   noncancelable operating leases expiring at various dates through March 2001.
   One of the facility leases is subject to a 4 percent annual escalation
   clause.  The Company incurred rental expense under these leases of $667,000,
   $620,000 and $596,000 in 1998, 1997 and 1996, respectively.  The approximate
   minimum rental commitments required under existing noncancelable leases as of
   December 31, 1998 are as follows:
<TABLE>
<CAPTION>
 
<S>                           <C>
                    1999      $  665,200
                    2000         584,774
                    2001          16,097
                    2002           3,610
                              ----------
                              $1,269,681
                              ==========
</TABLE>

   b.  Employment Agreement
       --------------------

   The Company has an employment agreement with the Chief Executive Officer
   which expires on July 5, 1999.  In addition to a base salary, the agreement
   provides for a bonus to be determined by the Compensation Committee of the
   Board of Directors.  No maximum compensation limit exists. Compensation
   expense pursuant to this agreement in 1998, 1997 and 1996 was $231,111,
   $232,964 and $231,729, respectively.

   c.  Legal Proceedings
       -----------------

   The Company is, from time to time, involved in various legal and other
   proceedings that relate to the ordinary course of operating its business,
   including, but not limited to, employment-related actions and workers'
   compensation claims.

   In October 1995 the Company was served with a complaint that was filed by
   four persons and the spouses of those persons, who are/were employed by one
   of the Company's customers.  The 

                                       57
<PAGE>
 
   complaint, filed in the United States District Court, Eastern District of
   Tennessee, alleges that the employees contracted chronic beryllium disease as
   a result of their exposure, during the course of their employment with the
   Company's customer, to beryllium-containing products sold by Ceradyne. The
   complaint seeks compensatory damages in the amount of $3.0 million for each
   of the four plaintiffs who were employed by the Company's customer,
   compensatory damages of $1.0 million each for the two spouses, and punitive
   damages in the amount of $5.0 million. Based upon information currently
   available, the Company believes that the plaintiffs' claims are without merit
   and that the resolution of this matter will not have a material adverse
   effect on the financial condition or operations of the Company. Defense of
   this case has been tendered to the Company's insurance carriers, some of
   which are providing a defense subject to a reservation of rights. There can
   be no assurance, however, that this claim or any of the claims related to
   exposure to beryllium oxide will be covered by insurance, or that, if
   covered, the amount of insurance will be sufficient to cover any potential
   judgment.

   In February 1997 the Company was served with a complaint that was filed by a
   former employee of one of the Company's customers and his wife.  The
   complaint, filed in the United States District Court, Eastern District of
   Tennessee, alleges that the husband contracted chronic beryllium disease as a
   result of his exposure to beryllium-containing products sold by Ceradyne.
   The complaint seeks compensatory damages in the amount of $5.0 million for
   the husband, $1.0 million for the wife, and punitive damages in the amount of
   $10.0 million.  The Company believes that the plaintiffs' claims are without
   merit and that the resolution of this matter will not have a material adverse
   effect on the financial condition or operations of the Company.  Defense of
   this case has been tendered to the Company's insurance carriers, some of
   which are providing a defense subject to a reservation of rights.  There can
   be no assurances, however, that this claim will be covered by insurance, or
   that, if covered, the amount of insurance will be sufficient to cover any
   potential judgment.

   In August 1997 the Company was served with a complaint filed by a former
   employee of one of the Company's customers and his wife. The complaint, filed
   in the United States District Court, Eastern District of Tennessee, alleges
   that the husband contracted chronic berylliium disease as a result of his
   exposure to beryllium-containing products sold by Ceradyne. The complaint
   seeks compensatory damages in the amount of $5.0 million for the husband,
   $1.0 million for the wife, and punitive damages in the amount of $10.0
   million. The Company believes that the plaintiffs' claims are without merit
   and that the resolution of this matter will not have a material adverse
   effect on the financial condition or operations of the Company. Defense of
   this case has been tendered to the Company's insurance carriers, some of
   which are providing defense and indemnification subject to a reservation of
   rights. There can be no assurances, however, that this claim will be covered
   by insurance, or that, if covered, the amount of insurance will be sufficient
   to cover any potential judgment.

   In February 1999 the Company was served with a complaint filed by a former
   employee of one of the Company's customers and his wife. The complaint, filed
   in the United States District Court, Eastern District of Tennessee, alleges
   that the husband contracted chronic beryllium disease as a result of his
   exposure to beryllium-containing products sold by Ceradyne. The complaint
   seeks compensatory damages in the amount of $5.0 million for the husband,
   $1.0 million for the wife, and punitive damages in the amount of $10.0
   million. The Company believes that the plaintiffs' claims are without merit
   and that the resolution of this matter will not have a material adverse

                                       58
<PAGE>
 
   effect on the financial condition or operations of the Company. Defense of
   this case has been tendered to the Company's insurance carriers. There can be
   no assurances, however, that this claim will be covered by insurance, or
   that, if covered, the amount of insurance will be sufficient to cover any
   potential judgment.

5. Disclosure About Segments of Enterprise and Related Information
   ---------------------------------------------------------------

In June 1997, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 131, "Disclosures About Segments of
an Enterprise and Related Information".  SFAS No. 131 establishes standards for
the way that public business enterprises report information about operating
segments.  The company has adopted No. 131 in fiscal 1998, as required.

The Company serves its markets and manages its business through three divisions,
each of which has its own manufacturing facilities and administrative and
selling functions.  The Company's Advanced Ceramic Operations, located in Costa
Mesa, California, primarily produces armor and orthodontic products, components
for semiconductor equipment, and houses the Company's SRBSN research and
development activities.  The Company's cathode development and production are
handled through its Semicon Associates division located in Lexington, Kentucky.
Fused silica products, including missile radomes, are produced at the Company's
Thermo Materials division located in Scottdale, Georgia.  Ceradyne's
manufacturing structure is summarized in the following table:

<TABLE>
<CAPTION>
==================================================================================================== 
            FACILITY LOCATION                               PRODUCTS
---------------------------------------------------------------------------------------------------- 
<S>                                    <C> 
Advanced Ceramic Operations            . Semiconductor Equipment Components
Costa Mesa, California                 . Lightweight ceramic armor
Approximately 74,000 square feet       . Orthodontic ceramic brackets
                                       . Ceralloy(R) 147 SRBSN wear parts
                                       . Precision ceramics
                                       . Ceralloy(R) 147 SRBSN diesel/automotive engine parts (R&D)
----------------------------------------------------------------------------------------------------- 
Semicon Associates                     . Microwave ceramic-impregnated dispenser cathodes
Lexington, Kentucky                    . Ion laser ceramic-impregnated dispenser cathodes
Approximately 35,000 square feet       . Samarium cobalt magnets
----------------------------------------------------------------------------------------------------- 
Thermo Materials                       . Glass tempering rolls (fused silica ceramics)
Scottdale, Georgia                     . Metallurgical tooling (fused silica ceramics)
Approximately 85,000 square feet       . Missile radomes (fused silica ceramics)
                                       . Castable and other fused silica product
=====================================================================================================
</TABLE>

                                       59
<PAGE>
 
                                 Ceradyne, Inc.
              Segment Statement of Operations for the Years Ended
                       December 31, 1998, 1997, and 1996
                             (amounts in thousands)
<TABLE>
<CAPTION>
 
                                                                                            
                           Advanced Ceramic Ops        Semicon Associates         Thermo Materials               TOTAL  
                        --------------------------   -----------------------  ------------------------  --------------------------  
                        1998       1997      1996     1998     1997    1996    1998     1997     1996     1998     1997      1996  
----------------------------------------------------------------------------------------------------------------------------------
<S>                    <C>       <C>       <C>       <C>     <C>      <C>     <C>      <C>      <C>     <C>      <C>       <C>    
Revenue from           $14,176   $17,202   $16,190   $5,995  $ 6,134  $6,601  $6,108   $5,357   $5,421  $26,279  $28,693   $28,212
 External              -------   -------   -------   ------  -------  ------  ------   ------   ------  -------  -------   -------
 Customers                                                                                                                        
                                                                                                                                  
Depreciation           $   992   $   843   $   612   $  301      293  $  441  $  212   $  225   $  231  $ 1,505  $ 1,361   $ 1,284
 and                   -------   -------   -------   ------  -------  ------  ------   ------   ------  -------  -------   -------
 Amortization                                                                                                                     
                                                                                                                                  
Segment Income         $    37   $ 2,356   $ 4,125   $ (114) $(2,045) $ (304) $  369   $   64   $  346  $   292  $   375   $ 4,167
 (loss) before         -------   -------   -------   ------  -------  ------  ------   ------   ------  -------  -------   -------
 provision                                                                                                                        
 (benefit) for                                                                                                                    
 income  taxes                                                                                                                    
                                                                                                                                  
Segment Assets         $19,960   $19,403   $17,171   $6,398  $ 6,362  $8,188  $3,135   $3,252   $3,039  $29,493  $29,017   $28,398
                       -------   -------   -------   ------  -------  ------  ------   ------   ------  -------  -------   -------
                                                                                                                                  
Expenditures           $ 1,827   $ 2,306   $ 1,766   $  272  $   479  $  508  $  114   $  102   $  367  $ 2,213  $ 2,887   $ 2,641
 for Segment           -------   -------   -------   ------  -------  ------  ------   ------   ------  -------  -------   -------
 Assets
                       -----------------------------------------------------------------------------------------------------------
</TABLE>

                    Segment Statement for Net Sales by Area
                              for the Years Ended
                       December 31, 1998, 1997, and 1996
                                     (in %)
<TABLE>
<CAPTION>
                                                                                    
                             Advanced Ceramic Ops       Semicon Associates      Thermo Materials              TOTAL
                          -------------------------   ---------------------   ---------------------   ---------------------
                           1998       1997     1996    1998    1997    1996    1998    1997    1996    1998    1997    1996   
---------------------------------------------------------------------------------------------------------------------------
<S>                         <C>        <C>      <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>   
U.S. Net Sales              47%        53%      51%     18%     14%     14%     19%     13%     15%     84%     80%     80%   
                                                                                                                             
Western Europe               4%         4%       2%      3%      3%      3%      2%      3%      2%      9%     10%      7%   
 Net Sales                                                                                                                   
                                                                                                                             
Asia Net Sales               1%         1%       3%      2%      4%      6%      1%    ---       1%      4%      5%     10%   
                                                                                                                             
Israel Net                   2%         1%       1%    ---     ---     ---     ---     ---     ---       2%      1%      1%   
 Sales                                                                                                                       
                                                                                                                             
Canada Net                 ---        ---      ---     ---     ---     ---       1%      1%      1%      1%      1%      1%   
 Sales                                                                                                                       
                                                                                                                             
Other                      ---          1%       1%    ---     ---     ---     ---       2%    ---     ---       3%      1%   
                          ----       ----     ----    ----    ----    ----    ----    ----    ----    ----    ----    ----   
                                                                                                                             
Total Net Sales             54%        60%      58%     23%     21%     23%     23%     19%     19%    100%    100%    100%   
                          ====       ====     ====    ====    ====    ====    ====    ====    ====    ====    ====    ====    
               --------------------------------------------------------------------------------------------------------------
</TABLE>

                                       60
<PAGE>
 
For fiscal year 1998, two customers accounted for approximately 16% and 11% of
net consolidated sales.  For fiscal year 1997, one customer accounted for
approximately 17% of net consolidated sales.  For fiscal year 1996, one customer
accounted for approximately 17% of net consolidated sales.

6.  Comprehensive Income
    --------------------

Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income" which established standards for the reporting and display
of comprehensive income and its components in financial statements.
Comprehensive income generally represents all changes in stockholder's equity
except those resulting from investments by and distributions to owners.
Currently, no difference exists between the Company's net income and its
comprehensive net income.

7.  Stock Options
    -------------

The Company has a stock option plan, the 1994 Stock Incentive Plan and an
employee stock purchase plan, the 1995 Employee Stock Purchase Plan.  The
Company had a 1985 Employee Stock Purchase Plan which expired on July 31, 1995.
The Company accounts for these plans under APB Opinion No. 25, under which no
compensation cost has been recognized.  Had compensation cost for these plans
been determined consistent with FASB Statement No. 123, the Company's net income
and earnings per share would have been reduced to the following pro forma
amounts:
<TABLE>
<CAPTION>
 
                                             1998        1997         1996    
                                           --------   ----------   ---------- 
<S>                          <C>           <C>        <C>          <C>        
   Net Income:               As Reported   $282,000   $2,050,000   $4,040,000 
                             Pro Forma       97,371    1,888,000    3,794,000 
                                                                              
   Basic income per share    As Reported   $    .04   $      .26   $      .52 
                             Pro Forma          .01          .24          .49 
                                                                              
   Diluted income per share  As Reported   $    .04   $      .26   $      .51 
                             Pro Forma          .01          .23          .48 
</TABLE>

Because the Statement No. 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years.
Additionally, the 1998, 1997 and 1996 pro forma net income include immaterial
amounts related to the purchase discount offered under the 1995 Employee Stock
Purchase Plan.

The Company may sell up to 100,000 shares of stock to its full-time employees
under the 1995 Employee Stock Purchase Plan.  The Company has sold 24,162,
22,004 and 13,694 shares in 1998, 1997 and 1996, respectively, under the 1995
Employee Stock Purchase Plan.  Employees may purchase shares at the lower of 85
percent of the quoted market value of the shares as determined on the first or
last day of the plan year.  The weighted average fair value of shares sold in
1998, 1997 and 1996 was $3.93, $4.63 and $4.75, respectively.

The Company may grant options for up to 650,000 shares under the 1994 Stock
Incentive Plan.  The Company has granted options for 606,700  shares through
December 31, 1998.  Options are granted at or above the fair market value at the
date of grant and generally become exerciseable over a five-year 

                                       61
<PAGE>
 
period.

A summary of the status of the Company's stock option plan at December 31, 1996,
1997 and 1998 and changes during the years then ended is presented in the table
and narrative below:
<TABLE>
<CAPTION>
 
                                                     Weighted Average
                                          Shares      Exercise  Price
                                         ---------   -----------------
<S>                                      <C>         <C>
OUTSTANDING, December 31, 1995            542,200              $ 3.01
                                         ========              ------
 
     Granted                               25,000                6.92
     Exercised                           (160,645)               2.74
     Canceled                             (22,505)               2.46
                                         --------              ------
     OUTSTANDING, December 31, 1996       384,050              $ 3.56
                                         ========              ------
 
     Granted                              139,500              $ 6.14
     Exercised                            (23,900)               2.85
     Canceled                             (33,800)               4.98
                                         --------              ------
     OUTSTANDING, December 31, 1997       465,850              $ 4.26
                                         ========              ------
 
     Granted                              128,500              $ 1.14
     Exercised                            (41,200)              ( .23)
     Canceled                             (55,000)               (.65)
                                         --------              ------
     OUTSTANDING, December 31, 1998       498,150              $ 3.98
                                         ========              ======
</TABLE>

Of the 498,150 options outstanding at December 31, 1998, 265,550 have exercise
prices between $2.00 and $4.375, with a weighted average exercise price of
$2.93, and a weighted average remaining contractual life of seven years.  The
remaining 232,600 options have exercise prices between $4.75 and $7.375, with a
weighted average exercise price of $5.76, and a weighted average remaining
contractual life of nine years.
 
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1998, 1997, and 1996, respectively:  risk free
interest rates of 5.4, 6.38 and 6.29 percent; expected lifes for 1998, 1997 and
1996 of 7 years; expected volatility of 94.87, 57.43 and 57.20 percent.  The
assumed dividend yield in 1998, 1997 and 1996 is zero percent.

8.  Supplemental Retirement Plan
    ----------------------------

In December 1988 the Board of Directors of the Company approved the adoption of
a supplemental retirement plan (Ceradyne SMART 401(K) Plan) in which
substantially all employees are eligible to participate after completing 90 days
of employment.  Participation in the Plan is voluntary.  An employee may elect
to contribute up to seven percent (7%) of the employee's pretax compensation as
a basic contribution.  The Company may contribute any amount which the Board of
Directors annually determines appropriate.  Company contributions fully vest and
are nonforfeitable after the participant has completed five years of service.
During the years ended December 31, 1998, 1997, and 1996, the related company
contribution was approximately $42,000, $116,000, and $117,000, respectively.

                                       62
<PAGE>
 
The Company's contribution is in the form of shares of its common stock.  The
number of shares to be contributed will be determined by dividing the total
Company match for the Plan year by the higher of the market value per share of
common stock as of the end of that Plan year (December 31), or the audited book
value per share of common stock as of the end of that Plan year.  The
participants' cash contributions may be invested, at their discretion, in one or
all of the following:  (1) Fixed Income Fund, (2) Bond and Mortgage Fund, (3)
International Stock Fund, or (4) Equity Fund.  The member can elect to allocate
the accumulated and future contributions to their accounts among these funds in
increments of 10 percent.

The Company has reserved 250,000 shares of its common stock for possible
issuance under the Plan.  At December 31, 1998, 125,897 shares were available
for issuance under the Plan.

9.  Interim Financial Information (unaudited)
    -----------------------------------------

The results by quarter for 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
 
                                                        Quarter Ending
                                                        --------------
                                   March 31,        June 30,      September 30,   December 31,
                                      1998            1998            1998            1998
                                 --------------   -------------   -------------   -------------
<S>                              <C>              <C>             <C>             <C>
 
 Net sales                           $7,341,000      $6,342,000      $6,290,000     $6,305,000
 Net income                             483,000         326,000          44,000       (571,000)
 Diluted income per
   share-                            $      .06      $      .04      $      .01     $     (.07)
                                     ==========      ==========      ==========     ==========
 
<CAPTION>  
                                                          Quarter Ending
                                                          --------------
                                      March 31,       June 30,      September 30,   December 31,
                                        1997            1997            1997           1997
                                     ----------      ----------     -----------     ----------
 
 Net sales                           $6,621,000      $7,280,000      $7,100,000     $7,692,000
 Net income                             284,000         759,000         508,000        499,000
 Diluted income per
   share-                            $      .04      $      .10      $      .06     $      .06
                                     ==========      ==========      ==========     ==========
</TABLE>

10. Joint Venture and Joint Development Agreement
    ---------------------------------------------

On March 11, 1986, the Company sold 526,316 shares of its common stock to Ford
Motor Company (Ford) for a gross sales price of $10,000,000.  In addition, Ford
and the Company formed a joint venture, Ceradyne Advanced Products, Inc. (CAPI),
in which the Company acquired a 20 percent interest for $200,000.  Ford
contributed certain technology in exchange for its 80 percent interest in the
joint venture.  The Company granted Ford an option to put Ford's 80 percent
interest in the joint venture to the Company in exchange for 608,020 shares of
the Company's common stock.  Ford granted the Company an option to call Ford's
80 percent interest in the joint venture in exchange for 680,983 shares of the
Company's common stock.

                                       63
<PAGE>
 
On February 13, 1988, the Company exercised its call option and issued 680,983
shares of its common stock to Ford.  The value of the shares issued ($2,043,000)
was allocated to the technology acquired and is being amortized over a 20 year
period utilizing the purchase method of accounting (see Note 1).

Ford and the Company have also entered into a joint development program to
develop a prototype production facility to produce ceramics with automotive
applications.  Under the terms of the joint development agreement, Ford and the
Company share equally in the cost of this project.  For the years ending
December 31, 1998, 1997 and 1996, Ford agreed to contribute $270,000, $270,000
and $275,000, respectively, which have been reflected as revenue in the
accompanying consolidated financial statements.

                                       64
<PAGE>
 
               SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS
               -------------------------------------------------
                                        
                             (Amounts in thousands)
<TABLE>
<CAPTION>
 
 
                          Balance    Charged                 Balance
                            at       to Costs                  at
                         Beginning     and                   End of
     Description         of Period   Expenses   Deductions   Period
----------------------   ---------   --------   ----------   -------
<S>                      <C>         <C>        <C>          <C>
 
For the Year Ending
December 31, 1998:
----------------------
 
Allowance for
doubtful
accounts receivable           $179       $ 55         $142      $ 92
                              ====       ====         ====      ====
 
For the Year Ending
December 31, 1997:
----------------------
 
Allowance for
doubtful
accounts receivable           $125       $134         $ 80      $179
                              ====       ====         ====      ====

For the Year Ending
December 31, 1996:
------------------

Allowance for
doubtful
accounts receivable           $150       $  0         $ 25      $125
                              ====       ====         ====      ====
</TABLE> 

                                       65
<PAGE>
 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

March 31, 1999           CERADYNE, INC.

                           By   /s/ JOEL P. MOSKOWITZ
                                --------------------------------------------
                                Joel P. Moskowitz
                                Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
<S>                            <C>                            <C>   
                               
/s/ JOEL P. MOSKOWITZ          Chairman of the Board,         March 31, 1999 
-------------------------      Chief Executive Officer,
 Joel P. Moskowitz             President and Director
                               (Principle executive
                               officer)
 
                               
/s/ HOWARD F. GEORGE           Chief Financial Officer        March 31, 1999   
-------------------------      (Principle financial
 Howard F. George              and accounting officer)
 
                                             
/s/ LEONARD M. ALLENSTEIN      Director                       March 31, 1999  
-------------------------
 Leonard M. Allenstein 


/s/ RICHARD A. ALLIEGRO        Director                       March 31, 1999 
-------------------------
 Richard A. Alliegro     


/s/ FRANK EDELSTEIN            Director                       March 31, 1999 
-------------------------
 Frank Edelstein       


/s/ PETER BEARDMORE            Director                       March 31, 1999
-------------------------
 Peter Beardmore       


/s/ MELVIN A. SHADER           Director                       March 31, 1999
-------------------------
 Melvin A. Shader      


/s/ MILTON L. LOHR             Director                       March 31, 1999
-------------------------
 Milton L. Lohr     

</TABLE> 
                                       66